


































































































































































































vv- 4 *V *> 



.* 4-° -n*. 

y > v 


°o *‘*t^* % a$P 

^ „ <• Of. AV ♦ !^w * 

* '. A- .V V« V /V .* 




> * vV«* 

„_V <v ** % 

* * * * a\^ 



V^V^* 4^ Cv 

# *»o° y 

*> V •I*. 9 * c 

v \ & :<m*' 

■ ': J\ : -%W*‘ 

4 *&* 

& o-.. ^ *V 

.4* 


• fcOy* 

* 

\ V , . „ 

y * * ®* O. *V i* fa.% v* 

K L° r£* n A v A < 

: v** : 

• o>^ ‘mlw* - 

* at ^ oVJIak* -V ^ * 


*b V 4, ■ 1 



s> *<v7** A 


$ ♦ 


0 A ♦ 




^ «*k *• 


«4>’ « »■« • „ *<£^ 

< 4 .w^*. % 


o • » 




« 

o. **T7T*’ A <^ '•.>•* A C 

' °o /\w^- \ / 

: ’bv 4 :£Mh** ++$ 



s A **rcC\^Z0^/h>° <?v c^ * fg j&T - '^. A^’ ♦ 0 

, £^L/A<> ^A 

•M ,: /\ W *. ._. 

^ '• • * ‘ /.... V^*, */' • * ** .*< 




-’bV 4 




,♦.-, % 



^r 0 

*. o< : 

• $' f +± 

• 4 ^ /% * c ^v^a/ 4* ^ J. 

^ *•••” ■$' % *"’* A 0 ^ 

i _.0 V .L^L% 

• ts. ^ .Wa' *<?„ t * 4 *\ 

r ^/V * AVW28 S.//A o 



* aV^ O 

1. ~^SfK*-S V + ° 

I* ♦TfW. /V 

. bK .-. .* .' 




A <-,'...* .0* <», *•> 

‘ *1^*. *+ (?* °o 



O’ . VV1% V 


^•0 

^*•*••• ... V**"’’’!/.... V 




V’ * l • 


r. ^ a* 

; v^ v * 


A °^r. 

* *j 




o’ .*v% 


’ ^ A 4 •* 

* A ■* 









-O ♦ 

*6 V . 






. r> ♦ rt .£» * s‘'l\'\ Vr' ' K » 

A* O *,,,.* <(r ^ A? L ’n m f\V <4 * 

» A * - ’ A u ^ * * * 0 <?> °^. • ' ’ • A 0 V 

> V *'•*» c\ ,<y *»*•'„. > 

„ A 1 ' fc V /^3^5Sb** o>. <1. * «61 .5) „* .4*0' i ,. 

^c,^ .*fl*»* ^ A' -aV/i- *. ^ .*se*. < 


aO v *VV% "> 

l* XV 4, - *> 

va • 

r ^v ♦ *? • 

* a ^ 1 * 



w . 


,,*'••** a^ ^ -o'.';* o v ^T7^* A 

O . * k ' * ♦ .Qr 0 ® * * 4 ^q *& 

A * WZ2*,* >, v *^^55^0.- o ♦♦ 

«bv* ;/«^-’ ^ 0 i •*.’^av. *•- V -* 

< o ' 

' A *■ < ^y7/Hl d ^ v 

* ° " 0 -V^ °^ *•»**• A 0 


• aV*^ o 

♦ ♦* ^ • 


<-y r * f 

. >° v -■ 




4> .... 




/ 

- V 0 * 

• +*$ 

A *>H^J>.>° ^°* < ' 0 V 

% ££{. *> '" V sv .....'♦e k "’ ./ .«^/V ‘ * * -y.. • ..V 

: WM % %A -'Sfc \ / .*SK' v * 

4: T ^ * Hi 4 X ( ; ' j. 4 X / ^ £. . j 

*„«» « A <£• 0*«wp^ , ▼ ^ -a7 ‘t 

■ *•* A v5, -..** A <?> -o.»* ,Cr \s ♦TtVs* A 

*- <y o°JL 9 * *b A % . t>«, 0^ o* -- # *b ‘ A V 

o j*» ^ ^ c u . s h^ °o .A 

V . * •* <y 




«5°, 


N v ^ '. 

<L^ O * - - * • 

* " 1 * ^° 



n * 





o V 

<5^. * ® « o 9 sy °4 *#»-»* a? 

.*’*»-. 'CV a 0’ .•V',. V v % .' •”. V .0^ . LVL' 

• A’- \ J? *jg^*. ^ ^ 4tt- ^ / »‘. 

*'T7i'*' vv^ t '<> **?.?•* # a' 'A .o 

A v . t < . ^ A o« • , ^ A> . fc , # ,r b A 

<A ^L c Q o 4^ ^ 

- A ' 




r ^ * o Vo °* A' 

V ^ c\ A* 

• 4° ■<?«. A * \ 

Tb A <^ 

^ w % A.V ,V- S ^ 





^V»* <6 



« C • 

* ^ 4 ' « 

■• ^ 

• <Lt V O * 

^ •••• y % 

* 4 . ♦ a » *r 

* r ,' i ^ft c o < 

* ^ * A 

* <L V VIa i! 

V AT?V A 

0 V 4|jr- 


A .-VHWNS. . &* C -’■*• 

V^'.V 


.0“ .*••'. T > 

v ,'^hr. % > /. 

: vv • 


' • o 




' / v* 

• > V " 

«* <?V A t t%L * 

: ^<b s - 

. A^ * 0 

<, -o.i* .0^ '*.A <> -o<i* Ay 

A v %*vvv ^ ^ ,0* 

A .*• ' 



0° ^.''.^\/ %.*• 

^ A^ ♦r(J\W / 0 L t, o A 

r V^ v • »WV, V v 

: a^ :P^ C a^ * 




C y 



_ _ + ^ - 

» >' m% <P\ * ® » 0 0 A 

*l*°* <^ Ap^ t v‘AL^ O ^ 

(vV/k* V ^ 


0! 



.* -K rv ‘. 

0 ^ °i. 

V” * * • •-> 

xv 4 , *£ 

• r?i A V * J 

; v^ v • 


• C^^rv 
■b o'. 

































































































































MATERIALS FOR THE STUDY 
OF BUSINESS 


Materials for the Study of Business 

Industrial Society. By Leon C. Marshall. 1,082 pages, cloth, 
$4.50, postpaid $4.65. 

Financial Organization of Society. By H. G. Moulton. 790 pages, 
cloth, $4.00, postpaid $4.12. 

Principles of Accounting. By Albert C. Hodge and J. O. McKinsey. 
390 pages, cloth, $3.00, postpaid $3.10. 

Law and Business. By William H. Spencer. 

Vol. I. Introduction. 612 pages, cloth. 

Vol. 11. Law and the Market. Law and Finance. 670 
pages, cloth. 

Vol. III. Law and Labor. Law and Risk-Bearing. Law 
and the Form of the Business Unit. 654 pages, 
cloth, $4.50, postpaid $4.62 each. 

Business Administration. By Leon C. Marshall. 920 pages, cloth, 
$4.00, postpaid $4.12. 

Education for Business. By Leverett S. Lyon. 618 pages, cloth, 
$3.50, postpaid $3.60. 

Social Studies in Secondary Schools. By a Commission of the 
Association of Collegiate Schools of Business. 114 pages, 
boards, $1.00, postpaid $1.10. 

Forms, Records, and Reports in Personnel Administration. Edited by 
C. N. Hitchcock. 162 pages, paper, $1.75, postpaid $1.79. 

Risk an< I Risk-Bearing. By Charles O. Hardy. 420 pages, cloth, 
$3.50, postpaid, $3.60. 

IN PREPARATION 

The Place of the Market in Our 
Economic Society. 

The Worker in Modern Economic 
Society. 

The Manager's Administration 
of Labor. 

The Physical Environment of 
Business. 

THE UNIVERSITY OF CHICAGO PRESS 

CHICAGO, ILLINOIS 


The Technique of Business Com¬ 
munication. 

Managerial Accounting. 

Commercial Banking Policies. 

Commercial Cost-Accounting. 

The Manager’s Administration 
of Finance. 





RISK AND RISK-BEARING 


THE UNIVERSITY OF CHICAGO PRESS 
CHICAGO, ILLINOIS 


THE BAKER & TAYLOR COMPANY 

NEW YORK 


THE CAMBRIDGE UNIVERSITY PRESS 

LONDON 

THE MARUZEN-KABUSHIKI-KAISHA 

TOKYO, OSAKA, KYOTO, FUKUOKA, SENDAI 

THE MISSION BOOK COMPANY 


SHANGHAI 




Risk and Risk-Bearing 


BY 

CHARLES 0. HARDY 

PROFESSOR OF ECONOMICS 
STATE UNIVERSITY OF IOWA 





THE UNIVERSITY OF CHICAGO PRESS 
CHICAGO, ILLINOIS 
















Copyright 1923 By 
The University of Chicago 


All Rights Reserved 


Published May 1923 


Composed and Printed By 
The University of Chicago Press 
Chicago, Illinois, U.S.A. 


JON11 *23 

©C1A705775 




EDITOR’S PREFACE 


Collegiate training for business administration is now so widely- 
attempted that the time has arrived when experiments should be 
conducted looking toward the organization of the business curriculum 
into a coherent whole. Training in scattered “business subjects” 
was defensible enough in the earlier days of collegiate business training, 
but such a method cannot be permanent. It must yield to a more 
comprehensive organization. 

There can be no doubt that many experiments will be conducted 
looking toward this goal; they are, indeed, already under way. This 
series, “Materials for the Study of Business,” marks one stage in such 
an experiment in the School of Commerce and Administration of the 
University of Chicago. 

It is appropriate that the hypotheses on which this experiment is 
being conducted be set forth. In general terms the reasoning back 
of the experiment runs as follows: The business executive administers 
his business under conditions imposed by his environment, both 
physical and social. The student should accordingly have an under¬ 
standing of the physical environment. This justifies attention to 
the earth sciences. He should also have an understanding of the 
social environment and must accordingly give attention to civics, law, 
economics, social psychology, and other branches of the social sciences. 
His knowledge of environment should not be too abstract in character. 
It should be given practical content, and should be closely related to 
his knowledge of the internal problems of management. This may be 
accomplished through a range of courses dealing with business admin¬ 
istration wherein the student may become acquainted with such mat¬ 
ters as the measuring aids of control, the communicating aids of 
control, organization policies and methods; the manager’s relation 
to production, to labor, to finance, to technology, to risk-bearing, 
to the market, to social control, etc. Business is, after all, a pecuni¬ 
arily organized scheme of gratifying human wants, and, properly 
understood, falls little short of being as broad, as inclusive, as life 
itself in its motives, aspirations, and social obligations. It falls 

little short of being as broad as all science in its technique. Training 

• • 
vu 


EDITOR’S PREFACE 


• • • 

Vlll 

BASIC ELEMENTS OF THE BUSINESS CURRICULUM 

Of problems of adjustment to 
-J' physical environment 

a) The earth sciences 

b ) The manager’s relationship 
to these 


Control 

1. Communicating aids of control, 

for example 

a) English 

b) Foreign language 

2. Measuring aids of control, for 

example 

a) Mathematics 

b) Statistics and accounting 

3. Standards and practices of con¬ 

trol 

a) Psychology 

b) Organization policies and 
methods 


Of problems of technology 

a) Physics through mechanics, 
basic, and other sciences 
as appropriate 

b) The manager’s administra¬ 
tion of production 

Of problems of finance 

a) The financial organization 
of society 

b) The manager’s adminis¬ 
tration of finance 

Of problems connected with the 
market 

a) Market functions and mar¬ 
ket structure 

« b) The manager’s administra¬ 
tion of marketing (including 
purchasing and traffic) 

Of problems of risk and risk¬ 
bearing 

a) The risk aspects of modern 
industrial society 

b) The manager’s administra¬ 
tion of risk-bearing 

Of problems of personnel 

a) The position of the worker 
in modern industrial society 

b) The manager’s administra¬ 
tion of personnel 

Of problems of adjustment to 
social environment 

a) The historical background 

b) The socio-economic insti¬ 
tutional life 

c) Business^law and govern¬ 
ment 






EDITOR’S PREFACE 


IX 


for the task of the business administrator must have breadth and 
depth comparable with those of the task. 

Stating the matter in another way, the modern business admin¬ 
istrator is essentially a solver of business problems—problems of busi¬ 
ness policy, of organization, and of operation. These problems, great 
in number and broad in scope, divide themselves into certain type 
groups, and in each type group there are certain classes of obstacles 
to be overcome, as well as certain aids, or materials of solution. 

If these problems are arranged (i) to show the significance of the 
organizing and administrative, or control, activities of the modern 
responsible manager, and (2) to indicate appropriate fields of train¬ 
ing, the diagram on the opposite page (which disregards much over¬ 
lapping and interacting) results. It sets forth the present hypothesis 
of the School of Commerce and Administration concerning the basic 
elements of the business curriculum, covering both secondary school 
and collegiate work. 

This present volume deals with the problems of risk and risk¬ 
bearing. 


L. C. Marshall 





AUTHOR’S PREFACE 


This volume grows out of an effort on the part of the Faculty of 
the School of Commerce and Administration of the University of Chi¬ 
cago to reorganize its curriculum so as to make its courses correspond 
to the functions performed in the process of providing present-day 
civilized society with economic goods. In view of the extent to 
which the book owes its existence to the need of a text to fill a gap 
in the equipment available for carrying out such a plan, this may 
be an appropriate place to indicate something of the nature of the 
instruction scheme in which a course in risk and risk-bearing finds a 
place. 

In his Freshman year, a student regularly takes a sequence of 
courses dealing with the whole field of economics and business adminis¬ 
tration, the usual sequence being Industrial Society, Value and 
Distribution, Business Administration. These courses are designed 
to give him a view of the whole field with which his later studies have 
to do, largely for the purpose of enabling him to approach the more 
detailed courses with a better grasp of the relationship between the 
things he is at the moment studying and the rest of the economic 
order. The course in Industrial Society, in particular, concerns itself 
with the interrelations of the various institutions which make up the 
economic organization of society. 

There follows during the Sophomore and Junior years a group of 
intermediate courses which together cover the entire field in more 
detail, each dealing with a specific social-economic function, the 
institutions through which this function is performed, and the prob¬ 
lems of administration which arise out of its performance. These 
functions are six: production (in the technological sense), finance, 
marketing, labor, risk-bearing, and social control. Courses dealing 
with these functions, together with another group which deals with 
the recording, facilitating, communicating, and computing aids to 
business administration 1 make up the backbone of the curriculum, 
and are required of all students, whereas advanced courses dealing 
with specific problems in these fields (such as investment analysis, 

1 Including accounting, statistics, business communication. 


xi 


AUTHOR’S PREFACE 


• • 
xn 

foreign trade, bank management, trade unions) are required only 
of students specializing in the given field. 

Of the six functions referred to, risk-bearing is the most likely 
to require explanation. As will be seen by an examination of the 
Table of Contents of this volume, the course out of which it has grown 
is made up of material much of which has traditionally been presented 
in courses in the theory of distribution, money and banking, insurance, 
investments, marketing, and speculation. To some, these elements 
may perhaps seem incongruous, and it may even be suspected that the 
principle of selection has been that of lumping together various odds 
and ends crowded out of other courses. Such a procedure might 
be justifiable. Indeed, from a practical point of view, one of the 
direct gains from the organization of the course was that it made 
possible the offering of what seems to the author an adequate amount 
of work in life and fire insurance, speculation, and business forecasting 
to meet the needs of the majority of students, without the necessity 
of injecting into each subject for administrative reasons a sufficient 
amount of material to fill out a conventional number of “student 
hours” to constitute a course. 

It is believed, however, that a course in “risk-bearing” has a 
stronger justification than administrative convenience. The connect¬ 
ing thread which runs through all the material is the influence of 
uncertainty. Indeed, it might be clearer to designate the course as a 
study of the influence of uncertainty on business affairs. Throughout 
most of our academic work in business management, emphasis is 
laid upon the importance of certainty. We are constantly reiterating 
the fact that efficient management involves scientific investigation 
to determine the important facts which bear upon our problems and 
careful study to insure that our plans shall reflect the significance of 
these facts. The author has no desire to minimize the force of this 
teaching. Nevertheless, there are definite limits to the application of 
scientific method in business. As is pointed out in detail in chapter 
iii, it is the persistent element of uncertainty which makes necessary 
the exercise of business judgment, and makes possible the reaping of 
business profit. The principal topics of this course, business fore¬ 
casting, investment and speculation, and insurance, serve well to 
bring out the difference between the two fundamental bases for a 
judgment of probability, on the one hand formulations of mathematical 
probabilities based on careful statistical investigation, on the other 
hand the comparison of data which are never sufficient to permit 


AUTHOR’S PREFACE 


xm 


an exact estimate of the chances of success or failure from a given 
line oh effort, yet do suffice to furnish a basis for an intelligent choice 
of’ alternatives. 

So widespread is the custom of including the bulk of the contents 
of this course under the heading of “finance,” that a further comment 
on the relation of finance to risk-bearing seems pertinent. It is quite 
possible to define “finance” so broadly as to include under its sway 
much of the domain here appropriated for “risk-bearing.” Indeed, 
it is possible to bring almost any business problem into the “financial” 
category, since the results of good or bad management almost invari¬ 
ably, given time enough, take the form of financial advantage or 
disadvantage. In the author’s judgment, however, clearness is gained 
by restricting the application of the term “financial” to such phases 
of business management as have to do with the acquisition of capital, 
the control of funds, the repayment of loans, and similar questions; 
in short, to the maintenance of an adequate supply of capital (including 
both that borrowed on short-time instruments and that permanently 
invested). To include in “finance,” as has been done by some 
writers, such matters as the question whether to expand the scope of 
one’s operations at the height of a boom, or the choice between two 
price policies, involves an overemphasis on one set of factors which 
must be considered in deciding such questions, and a neglect of the 
factors of sales management, technological efficiency, and risk which 
are more often effective in determining action than are any financial 
considerations concerning the proposed program. 

The section devoted to the business cycle illustrates the point 
of view upon which the book is based. Traditionally this subject 
has been assigned to the student of banking. Yet, whether we 
approach the problem from the angle of business management, and 
inquire what are the effects of the cycle on the administration of 
finances, the management of labor, and the production and sales policy, 
or whether we approach it from the angle of a student of economic 
theory and inquire whether the causes of the cycle are found in 
financial, market, or labor conditions, it is perfectly clear that the 
cycle is not merely a financial phenomenon, but pervades every 
aspect of our economic life. The common aspect of the problem 
which the cycle imposes upon the treasurer, the personnel adminis¬ 
trator, and the sales manager, is the element of uncertainty concerning 
the decisions other men are making. It is in each case as a risk- 



XIV 


AUTHOR’S PREFACE 


bearer that the manager must reckon with the periodicity of the 
phenomena with which he deals. The appropriate place for a survey 
of the causes of the cycle and the methods of forecasting or controlling 
it is in a course dealing with risk and risk-bearing; the appropriate 
place for discussion of the details of adjustment of the labor, the 
financial, and the sales policies to such forecasts, is in courses dealing 
with those functions. 

As is the case with other intermediate courses in the curriculum 
described above, no attempt is made to cover the entire field in 
exhaustive fashion. Rather it is intended to present simply the 
amount of material which every professional student of business 
can fairly be expected to include in a four year’s course, which must 
include his general business training, his specialized training for his 
particular line of endeavor, and whatever of literary and scientific 
education not strictly vocational he may secure in addition. For 
example, it is anticipated that students taking this course will elect 
additional work in investment analysis if their major interest is in 
finance; in insurance, if they expect to enter that field of employment; 
in marine insurance, either separately or in connection with courses 
in foreign trade, if they are looking to foreign commerce as a field of 
life-work, and so on. 1 

Although emphasis has been placed upon the way in which a course 
in risk and risk-bearing dovetails into a curriculum organized upon a 
functional basis, the attempt has been to organize the material in such 
a way that it can be used effectively with students having a different 
background. It is believed that the material can be presented 
advantageously to students having no other preliminary training than 
the customary introductory courses in economics. Colleges whose 
offerings in economics and business are more limited in number than 
is the case with the professional school of business may find a course 
in risk an effective way of reducing the number of courses needed to 
cover the fields touched upon, thereby making possible more extended 
work in other fields. The first ten chapters may be used conveniently 
as the introductory portion of an advanced course in investment 
analysis. Business men will find little that is new in the discussion 

1 Speculation is treated somewhat more fully than this general plan requires, 
with a view to making advanced courses unnecessary, chiefly because of the small 
number of students interested to take advanced courses in this field and the pau¬ 
city of material for use in such courses. 


AUTHOR’S PREFACE 


xv 


of their special fields of work, but may find value in the discussion of 
the interrelations of the different topics presented. 

My indebtedness to co-operating friends is very heavy. Dean 
L. C. Marshall has incurred a burden of responsibility for the appear¬ 
ance of a book dealing with this field, for its inception was due to his 
suggestion, and his unflagging interest and faith in the project made 
it possible for the material to be accumulated and subjected to the 
test of the classroom in its earlier as well as its later stages of develop¬ 
ment. He has also made innumerable suggestions of detail in connec¬ 
tion with the form in which the material is presented. To Professor 
F. H. Knight, my colleague in two universities, my debt is also 
unusually great, both for access to preliminary drafts of his book, 
Risk, Uncertainty, and Profit, during the period when my own ideas 
on the subject were first taking definite shape, and for innumerable 
helpful suggestions and clarifying criticisms. Professor Leverett S. 
Lyon has collaborated in the preparation of chapter xii, and has 
contributed much to the development of my view on many questions 
of theory. Professor A. S. Keister and Messrs. S. P. Meech and 
L. W. Mints have used preliminary mimeographed editions as text 
material, and have given me the benefit of their criticisms. Professors 
R. W. Stone and C. W. Wassam and Messrs. W. E. Atkins and H. C. 
Simons have read portions of the manuscript, and I have profited 
much by their suggestions. Grateful acknowledgment is made of the 
hearty co-operation of authors and publishers in connection with my 
requests for permission to use extended quotations. Mr. John E. Part¬ 
ington has rendered efficient aid in the preparation of the index. 

C. O. Hardy 

Iowa City 
April 14 , 1923 























. 


TABLE OF CONTENTS 


PAGE 


CHAPTER 

I. Forms and Extent of Business Risk. 

Universality of Risk. Sources. Risk in Production and in 
Marketing 

II. Ways of Dealing with Risk: Elimination of the Risk . io 

Methods of Dealing with Risk. Prevention. Research. 
Market Analysis. Time and Motion Study. Co-operation. 
Specialization. Combination of Risks. Reserves. Mathe¬ 
matics of Probability 

N HI. Ways of Dealing with Risk: Transfer to Others; As¬ 
sumption of Risk.32 

Specialization in Risk-Bearing. The Owner-Manager. Profit. 

Risk and Control. The Choice of Administrators. Business 
Judgment 

IV. Ways of Dealing with Risk: Transfer to Specialists— 


Continued .! .... 56 

Insurance. Hedging. Contracting Out 

V. Uncertainty and the Business Cycle .63 


Phases of the Cycle. Causes. Uncertainty in Producers’ 
Calculations. Uncertainty in Buyers’ Calculations. The 
Cycle in Production of Basic Capital. In Agricultural 
Production 

VI. Business Forecasting.84 

Methods. Interpretation of Prices. Index Numbers. Cor¬ 
poration Reports. Steel and Iron. Agricultural Produc¬ 
tion. Banking Conditions and Interest Rates. Composite 
Barometers 

VII. Risk and the Management of Capital.116 

Ways of Investing. Investment in One’s Own Business. 

In Repayment of Debts. Deposits with Financial Institu¬ 
tions. Security Investments. Personal Loans. Specula¬ 
tion. Gambling 


XVII 




XV111 


TABLE OF CONTENTS 


VIII. The Security Markets. 

The Market for Old Securities. The New York Stock 
Exchange. Functions. Trading Methods. Relations of 
Brokers with Customers. Deliveries. Information. Con¬ 
trol of the Exchange. Classes of Members. Short Selling. 
Wire Houses. Other Stock Exchanges. Trading Outside the 
Exchanges. The Market for New Securities. Investment 
Banks. Marketing Low Grade Securities 


PAGE 

128 


IX. Stock Speculation as Business Enterprise . . .157 

Traders’ Technique. Market Maxims. The Technical 
Position. Trading on the News. Manipulation. Proba¬ 
bilities of Success. Speculation for the Long Swing 


X. The Analysis of Securities. 

The Factors in Security Analysis. Tax Exemptions. Mar¬ 
ketability. Legality. United States Government Obliga¬ 
tions. Foreign Government Bonds. Industrial Securities. 
Analysis of the Industry. Financial Statements. The 
Balance Sheet. The Income Statement. Policy and Per¬ 
sonnel. Railway and Public Utility Securities. Diversifica¬ 
tion 


181 


XI. Speculation in Commodities. 

Organized and Unorganized Markets. Futures Contracts. 
Futures Markets. Delivery. Direct Settlement. Ringing 
Out. Transfer. Speculators’ Methods. Land Speculation 

XII. Hedging. 

Advantages of Hedging. Degree of Protection Afforded. 
A Supposititious Case. A Modification of the Assumptions. 
Relation of Spot Prices to Futures Prices. The Normal 
Spread. Conclusions 

XIII. Life Insurance. 

Insurance as a Hedge. The Risk Insured. Policy Contracts. 
Company Organization. Selection of Risks. Calculation of 
Premiums. The Net Premium. Loading. Disbursement of 
Funds. Expenses. Methods of Settlement. Surrender 
Values. Policy Loans. Group Insurance. Fraternal In¬ 
surance. Life Annuities. Disability Clauses. War Risk 
Insurance 


205 


223 


237 



TABLE OF CONTENTS 


XIX 


PAGE 

XIV. Fire Insurance. 2 88 

The Risk Insured. Policy Contracts. The New York 
Standard Policy. Mortgage Clause. Coinsurance. Three- 
quarter Value and Three-quarter Loss Clauses. Use and 
Occupancy Insurance. Company Organization. Stock. 
Mutual. Lloyd’s. Reciprocal. Rate Making. Public 
Control 

XV. Miscellaneous Property Insurance .320 

Marine Insurance. Tornado. Automobile. Crop. Credit. 
Miscellaneous Lines 

XVI. Guaranty and Suretyship .327 

Suretyship Compared with Insurance. Corporate Surety¬ 
ship. Advantages. Types of Protection. Insurance of 
Real Estate Titles. Bonded Abstracters. Title Guaranty. 
Torrens System 

XVII. Risks of Labor .336 

Types of Risk Carried by Labor. Unemployment. Sources. 

Cost. Ways of Dealing with Unemployment. Risk of 
Accident and Occupational Disease. Employers’ Liability. 
Workmen’s Compensation. Benefits. Compensation Insur¬ 
ance 

XVIII. Social Aspects of Risk-Bearing .355 

Profit Taking. Social Interference with Monopoly Profits. 
Dangers in Limiting Profits. A Fair Return. Profiteering. 

Risk and Control. Ethics of Gambling. Ethics of In¬ 
surance. Ethics of Speculation. Risk-Bearing and the 
Social Order. Risks of Modern Industry Compared with 
Medieval. Risk under Socialism 

















CHAPTER I 

FORMS AND EXTENT OF BUSINESS RISK 

Risk may be defined as uncertainty in regard to cost, loss, or 
damage. In this definition, emphasis is on the word uncertainty. 
Where destruction or loss of capital is certain in connection with a 
business process, it can be charged up in advance as a cost. It is not 
a risk. When the destruction or loss is uncertain, it may be dealt with 
in accordance with judgments of probability, and presents a problem 
in risk. In this chapter our task is to make a preliminary survey of 
the forms and extent of risk involved in present-day economic fife. 

It is a common statement that risk is universal. As one author 
puts it: 

The owner of wealth must, if he is rational, invest it in some productive 
enterprise, unless, under the circumstances, he decides to consume it; and, 
wherever it is invested, there will be some risk that part of it will be lost 
by the dishonesty of others, the deterioration in value of the property in 
which it is embodied, or in change of value of the standard of deferred 
payment. If he thinks to escape by hoarding it in the shape of specie, 
robbery is to be feared, to say nothing of the opportunities of gain which 
are given up. If he decides to consume the wealth at once, he runs the risk of 
coming to poverty. 1 

Or, in Professor Fisher’s words: 

If we take the history of the prices of stocks and bonds, we shall find it 
chiefly to consist of a record of changing estimates of futurity, due to what 
is called chance, rather than of a record of the foreknown approach and[ 
detachment of income. Few, if any, future events are entirely free from 
uncertainty. In fact, property, by its very definition, is simply the right to 
the chance of future services. A mine owner takes his chances as to what 
the mine w r ill yield; the owner of an orange plantation in Florida takes 
risks of winter frosts; the owner of a farm takes risks as to the effect of 
sun and rain and other meteorological conditions, as well as risks of ravages 
of fire, insects, and other pests. In buying an overcoat a man takes some 
risk as to its effectiveness in excluding cold, and as to the length of time it 
will continue to be serviceable. 2 

1 John Haynes, “Risk as an Economic Factor,” Quarterly Journal of Economics, 
IX, 410. 

2 Irving Fisher, Nature of Capital and Income , pp. 265-66. 


2 


RISK AND RISK-BEARING 


Statements such as these, though strictly accurate, are, neverthe¬ 
less, apt to give a false impression of the extent, or rather of the 
importance, of the unknown element in human calculations. All these 
manifold risks do exist, but most of them are of no practical conse¬ 
quence. The only risks which need be given consideration in a 
business decision, or for that matter in any other decision, are the 
cases where the property interest, or other interest, at stake on the 
outcome of a single uncertainty is large relative to the total of which 
it is a part. For example, the risk of windows being broken by small 
boys is a real risk for owners of expensive plate glass windows but is 
of no practical significance to owners of an equally large amount of 
capital in the form of many small windows. 1 Risk in any practical 
sense is not present in all our calculations. 

Uncertainties of practical importance to the business manager may 
conveniently be classified in accordance with their origin, as follows: 

1. Risks of destruction of property through the physical hazards of 
nature: storm, flood, fire, etc. These are among the most serious 
hazards in many lines of business, notably in five stock raising and 
in transportation. Most of the losses caused by hail, flood, and storm 
would be avoided if we knew in advance what conditions to expect. v 
They are part of the cost of our ignorance. To measure the total 
cost, however, we must add to the actual losses the cost of precautions 
taken against disasters which never occurred, and the loss of produc¬ 
tion on account of the existence of these risks. 

The magnitude of these losses reflects primarily the extremely 
rudimentary development of our science of weather forecasting. 
The extreme range of our ability to forecast deviations of weather 
from its past average is less than a week, and tolerably accurate 
forecasts can be made only twenty-four to forty-eight hours in advance. 
Even this limited range of forecasting, however, has tremendously 
reduced the volume of losses from weather conditions. 

2. Closely related to the preceding are uncertainties in the productive 
process. —In spite of the immense advance in applied science in the 
past 150 years, there still remain numerous points where commitment 
of capital is based on uncertainties. Strength of materials is one such 

1 Of course in the illustration given the coincidental breaking of all the small 
windows is a theoretical possibility, and, if it occurred, would be quite as serious 
as the breaking of the one large one. The point is that such coincidences are so 
extremely rare that their possibility may be disregarded entirely. The justifica¬ 
tion for this treatment of infinitesimal risks is developed more fully in chap, ii, 
note 1. 


FORMS AND EXTENT OF BUSINESS RISK 


3 


weak point in our applied science, particularly in the case of materials 
which have suffered depreciation in use. The effectiveness of labor is 
another point at which advance estimate and final result are apt to 
vary, and variations of weather make agricultural production notori¬ 
ously speculative. 

3. Social hazards include the risks due to deviations of individual 
conduct from what is expected , such as robbery, defalcation, and forgery, 
and also risks due to the impossibility of predicting the behavior of 
social groups. Strikes, riots, wars, tariff changes, tax reforms, pro¬ 
hibitory laws illustrate the range of these risks. 

4. Risks due to individual ignorance cause many losses and make 
possible many profits .—In a sense all risks are due to ignorance, for 
if all the conditions of any situation were known there would be no 
risk involved in it for anyone. There is, however, a distinction worth 
maintaining between risks due to the limitations of human knowledge^ 
and risks which are due to the failure or inability of individuals to take - 
advantage of the knowledge which is accessible to themselves or to 
those with whom they come into competition. It is risk of this 
character which keeps down the competition to seize favorable busi¬ 
ness openings and makes it possible for persons of superior knowledge 
and skill to profit by their superiority. Potential competitors are 
kept out of the field by their ignorance of its existence or its extent, 
and many who do enter are unable to compete effectively. 

5. Market risks form the most important group of all .—By market 
risks we mean the unavoidable uncertainties due to the fact that time 
elapses between the purchase and the sale of commodities, during 
which time unpredictable changes often occur in the prices and other 
market conditions surrounding the commodities dealt in. Rarely is 
it possible to conclude both the buying and the selling part of a 
given transaction simultaneously, so as to relieve the business man 
of risk, and -even when it can be done there is risk that he will be held 
to one contract and be unable to enforce the other. 

The extent to which the time element makes business risky has 
been indicated by President Hadley: 

Down to the present century, a large part of the speculative profits were 
made by taking advantage of differences of price in different places—chiefly 
in connection with foreign trade. The means of communication and trans¬ 
port were so defective that there was often a great scarcity of an article in 
one region and an abundance of the same article in another. The shipowners 
who moved the article from the latter place to the former had a chance of 


4 


RISK AND RISK-BEARING 


enormous profits. But the business was also attended by great risk. 
Transportation was far less safe, either from the elements or from human 
violence, than it is today. There was no telegraph, no good postal service, 
no efficient protection from pirates by sea or highway robbers by land. 
All these causes combined to render the arrival of goods so uncertain that 
the very wages of the seamen were made contingent upon the safe delivery 
of the cargo, and the whole body of sailors thus became participants in the 
speculation. 

The nineteenth century has witnessed a change in these respects. 
Improved means of communication have greatly lessened the differences in 
price in different markets. It is no longer possible to have a glut of wheat 
in Chicago and a scarcity in Liverpool. The modem post-office and the 
telegraph furnish prompt information of what is going on all over the 
world and enable merchants to know where goods are most needed. The 
steamship and the railroad furnish a quick and safe means of placing the 
goods where they will meet such needs as may arise. The difference of 
price of any staple article in two large wholesale markets will not generally 
be much greater than the cost of transportation from one to the other. 
So moderate have the profits from this source become that the business of 
those who try to secure them is now known as arbitrage rather than specula¬ 
tion. Only in the trade with barbarous or half-civilized races does foreign 
commerce retain its character as an extra-hazardous business. 

The speculator of today makes his money chiefly by taking advantage 
of differences of price between different times rather than between different 
markets. It is not so much the difference in the price of wheat in Chicago 
and in Liverpool which furnishes the source of his profits, as the difference 
between its price in Chicago this month and next month. When such 
speculation anticipates an actual demand, it is of great service to the com¬ 
munity. The long time which elapses between production and consump¬ 
tion, between contracts and their fulfilment, makes it extremely important 
to have responsible men to anticipate the wants of the market and take the 
risks on their own shoulders. 1 

It will be noted that from the standpoint of risk it makes no 
difference whether the buying or the selling occurs first. In many 
cases the business man contracts to deliver a certain commodity at a 
given price, then purchases the things he needs to fulfil his contract. 
The sale of a newspaper subscription, a building contract, the collec¬ 
tion of university tuition, are all transactions of this character. More 
frequent are the transactions where something is bought first with the 
idea of selling it, or some product into which it enters, at a profit. 

1 Adapted by permission from A. T. Hadley, Economics , pp. 104-5. (G. P. 

Putnam’s Sons, 1899.) 


FORMS AND EXTENT OF BUSINESS RISK 


5 


Sometimes both elements are present in the same transaction, as when 
a tailor first buys cloth, then after taking an order for a suit, buys the 
labor to make it up. In all transactions of either of these types, and 
it must be repeated that practically all business is of one type or the 
other, the longer the time involved in the fulfilment of obligations 
entered into, or in the disposal of commodities bought, the greater 
the risk of adverse changes, either in price or in other market condi¬ 
tions. Declines in price of one’s product occurring after capital has 
been sunk in plant and inventory have probably ruined more businesses 
than any other single group of causes. Increases in cost of materials 
and labor after contracting to sell one’s product are sometimes equally 
disruptive. Such changes in prices may be due to decline of demand 
arising from a change of consumers’ tastes—the collapse of the Ameri¬ 
can Bicycle Company is a good illustration; or to appearance of a 
more efficient method of production, as in the supplanting of hand 
weaving by factory processes; or to the appearance of a rival com¬ 
modity which renders a superior service, as when the tungsten filament 
supplanted the carbon for electric lighting purposes; or to changes 
in the general level of prices, as is illustrated by the decline of gold¬ 
mining during recent years of advancing prices. 

Of course the conditions which give rise to the chance of adverse 
changes also bring the chance of favorable changes. When the 
probability of such unpredictable changes, one way or the other, is 
considerable, and business is entered into with a view to profiting by 
a preponderance of favorable changes, the business is said to be of a 
speculative character. If the capital invested is highly specialized, 
the speculative element is increased because of the impossibility of 
recovering the investment if things go wrong with it. Real estate, 
grain, cotton, fresh fruit and vegetables, sugar, live cattle and hogs, 
horses are dealt in largely as speculative commodities, though in 
marketing many of these commodities it is feasible to reduce the 
speculative element in business by “hedging.” (See chap, xii.) 

In most lines of business profit does not depend upon favorable 
changes in the market, and the owner-manager would gladly give 
up his chance of profit from fluctuations of the market for the sake 
of freedom from its risks. The fluctuations, like the physical hazards 
referred to above, are a disturbing element, and though they may 
give rise to as many gains as losses, the necessity of taking precautions 
against them involves a cost which is a dead loss to the group as a 
whole. In strictly speculative lines, on the other hand, the fluctua- 


6 


RISK AND RISK-BEARING 


tions are the chief source of profit, though here also they may give 
rise to as many losses as gains. 

In relatively few cases does a highly speculative business derive 
its character from uncertainties in the productive process. Mining 
and oil-drilling furnish the best examples of this sort of risk. The 
development of inventions is highly speculative, partly because of 
market considerations and partly from uncertainties connected with 
production. 

The following comparison of the uncertainties involved in produc¬ 
tion and in marketing brings out other reasons for the emphasis which 
has been laid on the market as a source of risk: 

In the field of production, of course, the body of knowledge is on the 
whole better organized and more precise. The various systems of manage¬ 
ment relate more to production than to marketing. 

Though a vast field for research, marketing has had comparatively 
little scientific study. It has not seemed particularly susceptible to scientific 
study. It abounds in the human equation. This does not mean that much 
ability has not been expended on this field not only in studying and inciting 
demand but also in recording performance. Map and tack systems, quotas 
and bonuses, selling costs and carefully prepared statistics of various kinds 
have for a considerable period been employed by the most progressive selling 
organizations. These internal statistics have also been accompanied by 
external statistics affecting and reflecting market conditions. But in the 
last analysis, the figures finally used in, marketing, however obtained, are 
based on the law of averages, frequency, or proportion; the standards set, 
no matter how carefully and specifically adjusted, are in the last analysis 
averages, modes, or proportions and apply en masse rather than in detail. 
This does not mean that these data are not regarded as exceedingly valuable. 
Nevertheless a great problem in marketing is to get dowm beneath the law 
of averages and types. 

Production is so much more specialized and standardized, so much 
more precise than marketing, that it is possible, given certain facts of 
material, dimension, and design, to set a maximum time for the performance 
of a certain specific operation. The appliers of scientific management have, 
furthermore, shown the possibility of determining a minimum time for this 
operation with conditions continuing the same and of prescribing the means 
whereby this minimum time need not be exceeded. In other words, the 
scientific manager in production cannot only tell William Jones how long 
he should be in machining a certain part, but can furnish him with the best 
feeds and speeds to employ in doing the work in the time specified, and if 
the methods and time apply in Philadelphia it is presumed that they will 
also apply in Boston. But in marketing, no manager, no matter how able 


FORMS AND EXTENT OF BUSINESS RISK 


7 


and experienced, would attempt to tell Thomas Smith how long he should 
be in selling a pair of shoes to William Jones, nor to give more than general 
instructions as to the best way in which to do the selling. About the best 
this manager has been able to do is to say that in a week, on the average 
and according to the season, Thomas Smith should sell so many dollars’ 
worth of shoes. In machining the part, the conditions are more stand¬ 
ardized, the operation more specialized, the human factor is smaller and is 
more under control. In selling the shoes, the opposite is true. In produc¬ 
tion, the time for an operation can be measured by minutes and less; in 
marketing, I have encountered no practical use being made of units of less 
than one week. 

This warrants the consideration for a moment of certain fundamental 
differences between production and marketing. These differences may be 
balanced against each other as follows. In production, men meet only as 
members of the business—as subordinates, peers, or superiors. Neither 
the customer nor the competitor is encountered directly. In marketing, 
on the other hand, men are in contact not only with the other members 
of the business, but also with the customer to serve and the competitor to 
meet. In production, the problems are likely to be more those of cost— 
material, labor, and overhead. In marketing, the attention is more focused 
on price. Knowledge of cost is not particularly essential. The market is 
fixing values outside of the business’ control. Emphasis is also likely to 
be laid on quality and service. In production, the problems on the whole 
are internal. In marketing, the problems on the whole are external. Com¬ 
petition is on every hand. The market is to be analyzed. In production, 
there is probably for the individual business a possibility of greater inde¬ 
pendence of action. Marketing is probably more hedged about by the 
customs of the trade. In other words, as said before, marketing abounds 
in the human equation. 1 

The last sentence in the preceding selection touches one of the 
fundamental and irremovable elements of uncertainty in the business 
man’s problem. “Business touches the human equation.” That is, 
the decision of a business problem depends on a judgment as to what 
certain individuals will do under given, or partially given, circum¬ 
stances. This is always fraught with uncertainty, if for no other 
reason because if A’s decision depends on what B will do, and B’s 
decision on what A will do, it is obviously impossible for both to get 
all the data they need. The only way in which one can arrive, even 
in theory, at a scientific solution is through a rigid exclusion of free 

1 Adapted by permission from S. O. Martin, “Scientific Study of Marketing,” 
in Annals of the American Academy of Political and Social Science , LIX (1915), 
78-80. 


8 


RISK AND RISK-BEARING 


choice from his interpretation of human conduct; but on such an 
interpretation the business manager himself would have no interest 
in the result of his analysis anyway, as his own action would be 
determined outside his own choice. 

Moreover, quite apart from the theoretical impossibility of arriv¬ 
ing at a scientific judgment in matters of human conduct, the business 
manager runs quickly into serious practical difficulties. Time and 
cost set limits to the extent of his researches. No more than a general 
in the field can he wait till all the relevant facts have been gathered, 
nor can he afford to spend in their collection an amount greater than 
they will add to his profits. Even these limits he cannot definitely 
know. How much time, how much money it is worth while to spend 
in trying to complete the data on which to base a given decision, 
depends on facts which frequently cannot be known till the investiga¬ 
tion is complete and the decision has been made. 

In other words, the choice between two business policies or lines 
of action is in most cases not comparable to the solution of an algebraic 
equation, a type of problem where two trained minds may be expected 
to arrive invariably at the same conclusion. Sometimes it is rather 
like the translation of an inscription on a defaced monument where 
some of the words can be deciphered with ease, some can be made 
out with the aid of photography, and some can only be conjectured. 
Sometimes it is like a question of ethnography, where the expense of 
collecting data concerning an uncivilized race may make it necessary 
to depend on the unconfirmed accounts of a few travelers. Sometimes 
it is like the decision of a general in the field, where action must be 
taken at once, without waiting for the much desired information to 
arrive. 

The conclusion is not, however, that since we cannot know all we 
would like to know we cannot conduct ourselves rationally. If time 
or cost prevents our reaching a valid final judgment, there still remain 
several ways of meeting the situation. To these we will give atten¬ 
tion in chapter ii. 

QUESTIONS 

1. “The grower, the manufacturer, and the merchant must speculate.” 
Why? 

2. Are risks greater in a changing condition of industry ? in a market of 
greater time area ? 

3. Commercial speculation may concern itself either with the time area or 
the space area of the market. Explain. 


FORMS AND EXTENT OF BUSINESS RISK 


9 


4. How does the “roundaboutness” of modem industry affect risks? 

5. Explain how the presence of highly specialized capital goods in modern 
industry accentuates risk. 

6. Does expanding education have any tendency to increase risk ? 

7. How has the development of improved transportation and commu¬ 
nication affected risk ? 

8. Do you gather that risks are increasing ? Is there any answer to this 
question? Suppose they are increasing; is society worse off? 

9. “Business touches the human equation.” Explain. 

10. Try to outline what would be involved in a complete elimination of 
significant risk in our business life. 


CHAPTER II 


WAYS OF DEALING WITH RISK: ELIMINATION 

OF THE RISK 


It is clear enough that there is no escape, present or future, from 
the presence of uncertainty in the administration of business, and that 
we must accordingly deal with risk. The elimination of the risk 
requires the elimination, not of the loss or damage itself, but of the 
uncertainty concerning its time or place or extent. Usually this 
involves the substitution for the uncertain loss of a smaller but certain 
loss in one form or another. This cost, for instance, may consist of 
the price of a safety device, which may never be used or needed but 
if it is needed, may save many times its cost—it may be an insurance 
premium, or it may be the cost of an investigation to remove the 
uncertainty. 

Methods of dealing with risk may be analyzed into the following 
types: 


/ 


A. Elimination of risk by: 

1. Prevention of the harmful events 

2. Forecasting, or research to remove the uncertainty 

3. Combination of risks 

4. Accumulation of reserves to provide for meeting the risks 

5. “ Compensation,” or offsetting of risks 

B. Assumption of Risk 

1. By owner-managers 

2. By investors and speculators 

3. By laborers 

C. Transfer of risks to others 

1. Transfer to entrepreneurs, from 

(a) Laborers, through the wage system 
(&)^ajfftalists, through the interest system 

2. Contracting out 

3. Hedging 

4. Insurance 

5. Guaranty, suretyship, underwriting, etc. 


10 


WAYS OF DEALING WITH RISK: ELIMINATION 


II 


The present chapter deals with the various methods of eliminating 
risk. 

1. The prevention of harmful events is an ancient and universal 
method of reducing risk .—No very detailed discussion of this method 
of dealing with risk is necessary. Umbrellas, lightning rods, fireproof 
walls, and burglar alarms furnish everyday illustrations. Science and 
invention are constantly improving our technique for the removal of 
risk by prevention of harmful events, sometimes by the development 
of new methods, oftener by what is quite as important, the reduction 
of the cost of old methods. 

2. Reduction of risk by research has greatly increased in impor¬ 
tance .—As civilization advances the relative importance of science 
grows. On the one hand, the mass of accumulated information and 
experience requires more study and more specialization for its mastery; 
on the other hand, the complexity of the problems to be handled, the 
magnitude of the enterprises to be controlled, make such mastery 
ever more necessary. Just as in the latter part of the Middle Ages the 
trained lawyer gained control of the administration of justice, and a 
little later the physician wrested physic from the barber, so in the 
nineteenth and twentieth centuries the construction engineer sup¬ 
plants or directs the rule-of-thumb contractor, the works engineer 
who grew up in the plant gives way to the engineer with technical 
training, the trained nurse ousts the “practical nurse.” The increas¬ 
ing importance of science in business is merely one illustration of 
its increasing importance in all human affairs. 

The same factors which have brought about the development of 
scientific method in other fields have been operative in the field of 
business management, and here as in other fields the recognition of 
the value of exact knowledge and intelligent planning, though recent, 
has been very rapid. Whether the problem in hand is that of choos¬ 
ing a location, promoting an official, canceling a purchase order, refund¬ 
ing a bond, or writing an advertisement, the business manager has a 
choice of the two methods of procedure—snap judgment based on 
tradition, personal experience, haphazard information, and the cir¬ 
cumstances of the moment, or careful judgment based on investiga¬ 
tion of all the available data. So far as may be, he should rely upon 
the latter. One of the principal functions of formal education for 
business, indeed, is to indicate the value in business of modern methods 
of scientific analysis in such varied forms as the development of com¬ 
mercial research for the management of the market; of psychological 


12 


RISK AND RISK-BEARING 


and social investigation as a guide in the administration of personnel 
problems; of time study, laboratory analysis, and other technical 
methods of attack on the technical problems of production; of cost 
accounting as a guide in directing business policies. 

* The following selections describe certain aspects of the trend of 
business in recent years toward more exact scientific methods: 

MARKET ANALYSIS 1 

In order to determine to what particular class of customers his sales 
campaign should be directed, a manufacturer finds it necessary to study 
his market carefully under present conditions of keen competition. Blun¬ 
derbuss methods are wasteful; hence they are becoming antiquated. The 
demand for any article varies according to purchasing-power, living condi¬ 
tions, occupations, racial characteristics, climatic conditions, and numerous 
other influences affecting the different classes of consumers. The object of 
market analysis is to determine which class or classes of consumers con¬ 
stitute the potential market for the product, to ascertain where that class 
is located, and to find out what channels of distribution are most readily 
available for reaching them. 

There are few, if any, commodities for which equal per capita sales 
may be expected in all sections of the market, provided the market is more 
than local in its scope. In each district there are numerous classes of 
consumers with widely different tastes and desires, and the relative pro¬ 
portions of these classes in different districts always vary. In New York 
City, for example, the population of the metropolitan district in 1910 was 
6,475,000. In the same year the population of the Cleveland metropolitan 
district was 613,000. From these figures it cannot be assumed that the 
New York market for any particular article is potentially ten times as 
great as that of Cleveland. New York represents the extremes of wealth 
and poverty. Fifth Avenue and the Lower East Side are at opposite ends 
of the economic scale. Their wants and their purchasing power are wholly 
unlike and each differs from the large middle-class strata. In Cleveland 
the relative proportions of these several classes, with their numerous grada¬ 
tions of purchasing power and of wants, are not the same as in New York. 
The population of Cleveland, furthermore, differs in its composite parts from 
that of Cincinnati or other cities, and these differences in the make-up of 
the population affect potential demand. Another line of demarcation is 
between urban and rural districts. Because of these diversities a reliable 
estimate of potential demand can seldom be made upon a gross per capita 
basis. 

In analyzing the market for some products, conditions other than those 
of a strictly personal nature must be taken into account. A manufacturer 

1 Adapted by permission from M. T. Copeland, Business Statistics , pp. 178-83. 
(Harvard University Press.) 


WAYS OF DEALING WITH RISK: ELIMINATION 


13 


of electric flat-irons, for example, in analyzing his market found that in 
one city of 300,000 population 25,000 families were supplied with central 
station electric current. Thus there were 25,000 possible customers in 
that city. In another city of approximately the same size only 3,000 families 
were supplied with electric current; hence the potential market in this 
second city was much smaller. 

For some products the market is clearly defined; in such cases the 
market is easily analyzed by the manufacturer. The manufacturer of 
machine tools, for example, knows that his product can be sold only to 
machine shops and engineering works and his task is to learn all the establish¬ 
ments existing and planned for in the territory that he wishes to cover with 
his sales organization. A similar situation confronts other producers of 
equipment and materials that are sold to manufacturers. Certain manu¬ 
facturers of specialties sold to other classes of customers can encompass 
their market in a list that does not assume excessive proportions; a manu¬ 
facturer of surgical appliances, for example, can readily obtain and utilize 
a practically complete list of possible customers. For the great mass of 
goods sold at retail, however, and for general supplies sold to manufacturers, 
the market is of a different type and potential demand is much less easily 
estimated. 

In undertaking an analysis of the market for an article which is sold 
over a wide territory and for which a market index can be selected only 
with difficulty, too much attention may be given to wealth statistics, which 
are assumed to indicate incomes received by consumers. Wealth statistics, 
as a rule, have little significance in market analysis. In the first place, 
there are no reliable wealth statistics, and, in the second place, even if 
such statistics were available, they would give slight clue to the probable 
demand for any particular article. Wealth statistics are published, to be 
sure, by the United States government, but they are rough approximations. 

Wealth statistics are commonly reduced to a per capita basis, but a 
per capita wealth figure is of little worth for any purpose, for it does not 
show the distribution of the wealth. It makes a vast difference to manu¬ 
facturers looking for prospective markets whether the wealth in any district 
is fairly evenly distributed among the consumers or concentrated largely 
in the hands of a few very rich persons; the quantity of any commodity 
purchased by an individual consumer seldom varies in direct proportion to 
his -wealth or income. 

Finally, even if the wealth figures were available in such form that they 
could be relied upon and the distribution of the wealth among the popula¬ 
tion ascertained, the figures would not accurately indicate market potentiali¬ 
ties. Not only are wealth statistics inadequate indices of incomes, but 
different classes of people engaged in different occupations and living under 
different conditions do not expend their incomes in the same way, even if 
those incomes are approximately equal. 


14 


RISK AND RISK-BEARING 


Average wages are another set of statistics occasionally referred to as 
furnishing an index of potential demand. The United States Bureau of 
the Census publishes average wage statistics, and similar figures may be 
obtained from other sources. An average wage, however, for all the persons 
engaged in manufacturing in Massachusetts, for example, includes the 
wages of numerous highly skilled workmen and also the wages of unskilled 
men, women, and children. The average is not representative and does 
not indicate that Massachusetts is necessarily a poorer potential market 
for any manufacturer than some other states where the average wages may 
be higher. 

Per capita consumption figures for large groups of commodities, such 
as clothing or foodstuffs, are finding their way into some advertising pub¬ 
lications, as affording a guide to potential markets. The only per capita 
consumption figures which are worthy of consideration are those for such 
articles as coffee or sugar, where fairly accurate records of importation and 
domestic production are maintained. The census figures for the value of 
the product of the various manufacturing industries are too inaccurate, in 
the form in which they are presented, to be acceptable as a basis for estimates 
of per capita consumption, and there is too great uncertainty as to the 
amounts added to the manufacturers’ selling prices in the course of the 
marketing processes to warrant placing any reliance upon estimates of 
total retail selling value or total amounts paid by consumers for these 
products. These per capita consumption figures, moreover, are gross 
figures including many grades and qualities, some of which are virtually 
non-competing. Such statistics are of little aid in making a careful market 
analysis. 

Instead of attempting to use statistics for wealth, income, or per capita 
consumption, the first task in undertaking a statistical analysis of a market 
is properly to determine just what class or classes of consumers constitute 
the potential market and, if there are varying degrees of demand, what 
demand may be expected from each class. For this, personal investigation 
or inquiry may be necessary. The next step is to ascertain the number 
of consumers of each class in each sales district. From these two sets of 
statistics the total potential demand for each district under normal condi¬ 
tions can be estimated. 

These figures for estimated potential demand, when compared with past 
sales records, show in which districts the best opportunities exist for sales 
development and serve as a basis for establishing quotas for salesmen. 
Ordinarily the comparison of sales records with estimated potential demand 
shows that the degree of saturation is not uniform in all markets. It is 
usually found upon investigation that a higher percentage of potential 
demand has been realized in some markets than in others, thus indicating 
the direction in which expansion may most readily take place. 


WAYS OF DEALING WITH RISK: ELIMINATION 


15 

Another factor to which attention may be given in analyzing a market 
for some products is the percentage of distribution—that is, the percentage 
of the total number of possible retail outlets in which the goods in question 
are sold. A manufacturer of a food product sold in retail grocery stores 
generally wishes to induce as large a number of grocers as possible in each 
district to carry his product. If 75 per cent of the retail grocery stores are 
selling the article, he considers that he has 75 per cent distribution, without 
reference, of course, to the relative volume of trade of the retailers. 

In establishing sales quotas, allowances must be made not only for 
differences in degree of saturation and percentages of distribution but also 
for differences in general business conditions. From season to season general 
business conditions fluctuate in each district. A poor cotton crop may cut 
down the normal demand in the cotton states while a good grain crop in 
the same year may cause business to be exceptionally brisk in the wheat 
district. Hence the statistical indices of business conditions in each 
district must be taken into account in comparing salesmen’s records with 
established quotas. 

TIME AND MOTION STUDY 1 

According to. statements made by scientific managers, the process of 
analysis, or time and motion study, in the larger sense, should where 
possible begin with the determination of a site for manufacture. The 
really scientific manager, starting out de novo , will consider all available 
sites with reference to the time and motion expenditure, determined 
by actual experiment, necessary in securing an adequate supply of proper 
materials, in the going to and from the shop of the numbers of the different 
classes of workmen needed or likely to be needed, in the shipment and 
marketing of the product, etc. Having in mind the character of the 
productive process, and the most efficient productive arrangements possible, 
he will then, with regard to the greatest possible saving of waste time and 
motion, work out with the utmost care and with reference to future expansion 
the plans for the construction of his plant. This will involve a most careful 
study of all the general internal arrangements and processes, the most 
efficient methods of planning the work to be done and of routing it through 
the shop so that there may be no delay in transmitting orders, no waste 
carriage of materials and partly finished products, no lost time in the 
assembly room waiting for delayed parts. With the same ends in view, 
and in the same manner, he will also determine the most effective placement 
of machinery, the storage of tools and materials, and the location of the 
various elements of the office force. 

The shop constructed and the machinery installed, he will apply time 
and motion study in an endless series of experimental tests to determine 

1 Adapted by permission from R. F. Hoxie, “Scientific Management and 
Labor Welfare,” Journal of Political Economy, XXIV (1916), 833-43. 


i6 


RISK AND RISK-BEARING 


what possible improvements can be made in machinery and its operation, 
and in the tools, fixtures, materials, and specific processes of work. The 
best feed and speed for each machine, with reference to the different grades 
of materials, will then be established. The different jobs or processes will 
be analyzed and re-analyzed, and their elements experimentally combined 
and recombined, the tools and fixtures changed and rearranged, and all 
these variations timed and retimed in an effort to discover the most efficient 
productive combinations and methods. 

This time and motion study analysis will extend, it is thus claimed, to 
every feature and all organic relationships of the mechanical process of 
production. But it will not stop there. It will be extended to cover the 
managerial functions and the office work. The duties of the managers, 
superintendents, and especially of the shop foremen will be analytically 
studied and reorganized. The methods of storage and delivery of tools and 
materials, the dispatching of orders from the office to the shop, the purchas¬ 
ing of materials, the marketing of products, and all the methods of account¬ 
ing will likewise be subjected to time and motion study, in this larger sense, 

with a view to discovering the most efficient means and methods. 

It will endeavor to discover by repeated analysis and experimental timing 
the best character, combination, and arrangement of tools, materials, 
machinery, and workmen, the most efficient and convenient lighting, heat¬ 
ing, and seating arrangements for the workmen, the proper period for con¬ 
tinuous operation by them, considering the element of fatigue, the rest 
periods needed, their most efficient character, combination, and sequence 
of motions, etc. Moreover, these particular job experiments will not be 
confined to one man, or to a few of those who are to accomplish the task. 
Many men will be timed with the idea of discovering, not the fastest speed 
of the fastest man, but the normal speed which the group can continuously 
maintain. If necessary, hundreds and perhaps thousands of time and 
motion studies will be made to determine this before the task is set and the 
rate established. And whenever a new or better method or combination 
has been discovered by the time and motion analysis, which is supposed to 
continue even after the task is set, the whole process of careful and extended 
timing for task-setting will be repeated, and new tasks and rates established 
reasonably conformable to the new conditions. 

Finally, as an integral part of this broader time and motion study, all 
the results secured by it will be continuously and systematically filed as a 
permanent asset and guide to future action. Thus conceived, time and 
motion study appears to be considered a method of analysis applicable to 
practically every feature of the productive and distributive process, con¬ 
sidered apart from its purely financial aspects, a process of analysis applied 
continuously throughout the life of the establishment. And the scientific 
management based upon it is conceived to be a perpetual attempt to dis¬ 
cover and put into operation the new and continuously developing technical, 



WAYS OF DEALING WITH RISK: ELIMINATION 


17 


organic, and human arrangements, methods, and relationships constantly 
revealed by it to be more efficient and more equitable. That this broader 
conception of time and motion study as the essential basis of scientific 
managements exists not as a mere dream, but as a practical ideal striven 
for with the confident hope of realization, the writer can attest from his 
experiences in the best class of scientific-management shops. 

Although the drift in the direction of scientific method is clear, the 
extent to which the standards of exact science can be maintained 
varies greatly with th^character of the facts to be handled. In the 
physical sciences no lution is accepted which does not square with 
all the known facts, ^id if not all the relevant facts are known, judg¬ 
ment must be suspended till they can be secured by observation or 
by experiment. In this realm, no truly scientific judgment rests on 
estimates. This is less true of the biological sciences, and still less of 
the social sciences. In psychology, philology, ethics, sociology, educa¬ 
tion, economics, the phenomena are so complex, the objects of study 
are so heterogeneous, and the mass of relevant data is so enormous that 
resort must often be had to samples instead of complete data, esti¬ 
mates frequently take the place of measurements, and evidence which 
falls far short of meeting the standards of the exact sciences is ne¬ 
cessarily accepted as a basis for generalization. Consequently 
conclusions must be less final. This is true partly because of con¬ 
siderations of time and partly because of considerations of cost . 1 
The student of astronomy can afford to wait for years for the reappear¬ 
ance of a comet or of a total eclipse to confirm or disprove his 
hypothesis, the physicist can spend enough money on a single experi¬ 
ment to make sure the conclusions are right, knowing that if the 
measurements are exact the experiment need not be repeated, but the 
educator, the military scientist, or the anthropologist cannot as a 
rule test his theories completely in the laboratory. He cannot even 
expend the funds necessary to observe the world-wide variations of 
the phenomenon he is studying. And yet he cannot, if his science is 
to have any practical application, defer judgment till the evolution of 
society has confirmed or disproved his views. Hence he must speak 
in terms of preponderance of evidence, of typical results, of tendencies, 
and of probable results from given lines of conduct. 

1 It is perhaps worth noting that time and cost are not entirely separable 
elements. Often they depend on one another, that is, it is possible to shorten the 
time of an investigation if cost can be disregarded, or to avoid the cost if one can 
wait long enough for the facts to become clear. 


i8 


RISK AND RISK-BEARING 


The same contrast appears in the attempt to apply the scientific 
method to the solution of business problems which we have seen in 
its application to problems of thought and of knowledge. In dealing 
with certain types of data, highly exact measurements are possible, 
and the results repeat themselves with accuracy. Questions of the 
technique of machine industry are of this type, so long as comparisons 
of prices (of cost goods and output) are excluded, and even these over 
short periods of time are susceptible of very reliable estimation. It 
is in this field, therefore, that scientific management has made the 
most rapid strides. The value of accuracy and of scientific planning 
is no longer a question; the engineer has won his place. On the 
other hand, as was noted in chapter i, in agricultural production the 
incalculable element of weather makes it impossible to predict results 
with the same accuracy, and in marketing, finance, and labor admin¬ 
istration uncertainties abound, some due merely to the undeveloped 
state of the science of business research, others impossible to avoid. 

There are very definite limits to the extent to which individual busi¬ 
nesses find it to their advantages to eliminate risk either through research 
or through protective devices. The determining consideration is one 
of cost, and there are many fields in which it remains true that it is 
cheaper to run risks than to avoid them. Cost of elimination of 
risk, moreover, is often in the nature of a fixed charge. One night 
watchman, for example, can keep guard over numerous buildings 
almost as well as over one. One lighthouse warns thousands of vessels. 
Once the research necessary to establish a new truth has been com¬ 
pleted it costs little to impart the results to many businesses and 
perpetuate it for future generations. But the original costs of obtain¬ 
ing the information may involve a large investment with a high degree 
of risk that nothing useful will be learned. The larger the volume of*/ 
business, the more likely is this fixed charge to be a good investment; 
hence a strong tendency shows itself, other things being equal, for 
risky enterprises to be carried by large-scale methods. 

The same advantage may be gained by either of two other 
methods — co-operation and specialization. 

In the co-operative method the cost of research or protection is divided 
directly among a large number of business units. This method of 
reducing risk is well illustrated by many of the activities of govern¬ 
ment. Weather-forecasting has reduced immensely the risks of loss 
and damage to property on account of frost and flood. No single 
business could afford to maintain a weather-forecasting service of the 


WAYS OF DEALING WITH RISK: ELIMINATION 


19 


scope of that provided by the government, yet when the cost of this 
service is spread over all the lines of business which profit by it, it 
makes only a trifling addition to the burden of taxation. Research 
undertaken by the Department of Agriculture, the Department of 
Commerce, consular bureaus, and the Geological Survey has resulted 
in large additions to our store of exact knowledge in fields where a 
few years ago production was prevented or made hazardous by a lack 
of sufficient facts on which to base a valid judgment. In like manner 
government may be shown to be our most important co-operative 
device for eliminating risk through prevention of harmful events. The 
maintenance of fire departments and of lighthouses and many other 
phases of government activity are merely co-operative methods of 
eliminating the risks of production through activities which would be 
far too costly for single businesses, but which are very economical 
when their cost is divided among all who benefit from them. 

Other co-operative devices besides government may be used in 
the same way. Chambers of commerce maintain bureaus of exchange 
of credit information to lessen the risk of bad debts. In small com¬ 
munities they often contribute to the support of night watchmen to 
supplement the protection afforded by the city police. Trade associa¬ 
tions reduce risk by the maintenance of research organizations. This 
is but a beginning of a very long list. 

A second characteristic modern method of spreading the cost of 
research over a large number of business units is the development of 
specialists who furnish the service for pay. This method is illustrated 
by such diverse enterprises as clipping bureaus, advertising agencies, 
investors’ service bureaus. A very recent development of this sort 
is the specialized labor service bureau whose chief business is the 
collection of data for trade-union use in labor disputes. 

3. Elimination of risks by combination increases in importance with 
the development of large-scale enterprise. —By combination of risks is 
meant a grouping of similar items in such a way that we can tell more 
about the group than we can about the items which compose it. 
Elimination of risk by combination is the application of the so-called 
law of large numbers. It is often the case that we have a high degree 
of certainty about a group of data while at the same time we are in 
complete ignorance about the particular items which make up the 
group. Thus we may be quite sure that we can predict within 30 
per cent the amount of rainfall which will occur in a given region in 
the next year, while if we try to predict the precipitation for any 


20 


RISK AND RISK-BEARING 


particular week, it is more likely than not that the actual result will 
be either less than io per cent or more than 1,000 per cent of our esti¬ 
mate. So with death rates, marriages, enrolments in colleges, deser¬ 
tions from the army, accidents due to fireworks, and thousands of 
other contingencies. A single event defies prediction, but the mass 
remains always practically the same or varies in ways which we can 
predict. It is obvious that any device by which we can base our 
business decisions on the average which we can predict, instead of on v 
the single event, which is uncertain, means the elimination of risk. 
The larger the number of cases observed the less is the deviation of 
results from those which a priori were most probable. (Cf. note i,p. 27.) 

In the following selection Professor Ross elaborates a number of 
applications of the principle of combination of risks: 

The uncertainty as regards the yield of product sets up a current of 
amalgamation that favors large-scale industry. In almost any line of pro¬ 
duction minor fluctuations are constantly occurring in the different parts 
of a business. As, however, these succumb to an average within the single 
enterprise, they inspire no uncertainty and are not disturbing factors. 
The larger the enterprise the more do the variations incident to its branch 
of production reduce to an average and disappear, the fewer are the uncom¬ 
prehended species of variation. For instance, to the owner of a cow the 
loss at calving time is uncertain, while to the owner of a great herd this loss 
appears as a regular percentage that can be computed and allowed for. 
Even to the rancher the loss by stampede is uncertain, but to a great cattle 
syndicate with many herds, the loss from this source can be roughly esti¬ 
mated in advance. Again, in a small refinery the possibility of over-doing 
a batch of oil or sugar may be a source of serious uncertainty, while in a 
large refinery the law of the average prevails. 

But with a rapid growth in the size of the business unit, the great 
fortunes prove too few to handle the big enterprises. Hence the joint-stock 
corporation is invoked to supply masses of capital without calling on the 
rich man. Albeit the stimulus to corporate enterprise has been ascribed 
to the growth of great industry, no small measure of its success has been due 
to its fitness for uncertain undertakings. By owning stock in a dozen differ- v 
ent corporations and sharing in a dozen undertakings, one is exposed to 
twelve times as many variations, but each disturbs only one-twelfth as | 
much as when one is proprietor of a single enterprise. Some of the numerous 
variations will cancel each other, and the rest will locate their effects at the / 
margin of one’s fortune, where the subjective value of equal losses and / 
gains is nearly the same. ' J 

The corporate form, therefore, is at its best a mutual insurance scheme, 
whereby the losses and gains due to variations are first pooled, and then 


WAYS OF DEALING WITH RISK: ELIMINATION 


21 


shared equitably among a large number. By thus enlarging the bearing 
and absorbing surface, by creating solidarity through the interlacing of 
many private interests, the difference between the variable and the uniform 
type of production is minimized. While there is a corporate drift all over 
the field of business, we find it most pronounced in speculative branches, 
such as mining, boring for oil or gas, electric enterprise, building and 
improvement undertakings, the theatre business, and the introduction of 
new devices, machines, utensils, toys, foods, fibers, fuels, etc. 1 

4. Risks may be lessened by the maintenance of reserves , i.e., the 
withholding of resources from use to have them in readiness for a 
contingency which may or may not appear. Even in seasons of most 
active business, the existence of risk prevents the employment of our 
resources to 100 per cent capacity. Some items may be utilized to 
capacity or beyond proper capacity, but in many departments there 
are always some reserves of capital not actively employed. Thus the 
manager of a bank, in addition to the funds he expects to need from 
day to day, carries in his vaults a sum of idle money which he probably 
will not need, but which at some time he may need very badly. The 
grocer carries a little bigger stock than he will probably need before 
he can secure another shipment. Financial managers refuse to pay 
out in dividends the entire earnings of their firms, or even the full 
amount which can apparently be spared. Manufacturers carry extra 
stocks of raw materials and of repair parts. Such reserves are not 
entirely due to the risk. They may be accounted for by economies 
in manufacture or transportation of large units, but in large part they 
are necessitated by the presence of risk. 

The loss of production due to the idleness of the capital reserve 
cannot properly be called a waste. Its maintenance is a cost —the cost 
of uncertainty. Whether it is a social waste depends on the question 
whether the uncertainty can be removed at a cost less than the loss 
of production from the maintenance of the reserve. In large part, 
the uncertainty is of course quite beyond our powers to remove, and 
the maintenance of the reserve may be the most economical way to 
deal with it. So long as this is true, the cost of maintaining reserves 
is no more a “waste” than is the wear and tear on machinery or the 
cost of raw materials used up. 

Professor Pigou has pointed out the way in which the develop¬ 
ment of a more coherent social organization has made possible a more 

1 Adapted by permission from E. A. Ross, “Uncertainty as a Factor in Pro¬ 
duction,” in Annals of the American Academy of Political and Social Science , VIII 
(1896), 115-19- 


22 


RISK AND RISK-BEARING 


effective combination of risks and thereby rendered the maintenance 
of reserves less necessary: 

The development in the means of communication facilitates the com¬ 
bination of uncertainties in one very simple way. It puts investors into 
contact with a greater number of different openings than were formerly 
available. This effect, though of great importance, is so obvious and direct 
that no comment upon it is required. There is, however, a more subtle way 
in which the development in the means of communication works. Dr. 
Cassel has observed that industrial firms have, in recent times, been lessen¬ 
ing the quantity of stock that they carry in store, waiting to be worked up 
relatively to their total business. The improvement in this respect applies 
all round. As regards production, “ there is, in the best-organized industries, 
very little in the way of material lying idle between two different acts of 
production, even if these acts have to be carried out in different factories, 
perhaps at great distances from each other. A modern iron-works has no 
large stock either of raw materials or of their product, yet there is a con¬ 
tinuous stream of ore and coal entering, and of iron being turned out of it.” 
In like manner, factories are coming to keep a smaller amount of capital 
locked up in the form of reserve machines not ordinarily in use. The same 
tendency is apparent in retail trading. The ratio of the average amount 
of stock kept to the aggregate annual turn-over is smaller than it used to be. 

Now, prima facie, this change of custom w’ould seem to be of little 
significance. After all, a reduction in the amount of finished goods held by 
retailers, of reserve machinery held by manufacturers, and so on, does not 
necessarily imply a reduction in the aggregate amount of these things held 
by the whole body of industrials. On the contrary, we are naturally inclined 
to suggest that the wholesaler and the machine-maker must increase their 
stocks pari passu with the decrease in the stocks of their clients. As a 
matter of fact, however, this suggestion is incorrect. The reason is that 
the wholesaler and the machine-maker represent points at which uncertain¬ 
ties can be combined. The development of the means of communication, 
therefore, in so far as it directly transfers to them the task of bearing uncer¬ 
tainty, indirectly lessens the amount of uncertainty that needs to be borne. 
Uncertainty-bearing, in short, is rendered more efficient. 1 

Another writer has shown that combination of risks operates in 
exactly the same way to reduce the necessary social reserves of 
unemployed labor: 

The irreducible minimum of unemployment does not appear only in 
the general percentage for all trades taken together, it is shown also by each 
trade or group of trades taken separately. 

1 A. C. Pigou, Wealth and Welfare, pp. ioo, ioi. (The Macmillan Co.) 



WAYS OF DEALING WITH RISK: ELIMINATION 


23 


It holds true not of decaying industries but of those on which the 
development of the nation’s prosperity has been based. For each group, 
indeed, taken as a whole, there appears to be much the same irreducible 
minimum below which the year’s unemployment percentage never falls. 
Depression of trade is marked by very varying maxima. In the best years 
all the groups alike tend to have about two per cent, unemployed. An 
excess of the supply of labour over the demand appears to be a normal 
condition in the skilled and organized trades. 

Suppose that ten centres of casual employment—say ten similar 
wharves—each employ from 50 to 100 men on any one day, so that each 
considered separately requires a regular staff of 50 and a “reserve” of 50 
more. In so far as the variations of work depend upon general causes, 
affecting all the wharves simultaneously and similarly, the busy and slack 
times respectively will tend to coincide and the variations in the total work 
to reproduce proportionately those of each separate wharf. In so far, 
however, as the variations at different wharves are unconnected, they will, 
in the total of men required at all the ten from day to day, tend to neutralise 
one another, because a busy time at some wharves will coincide with a 
slack time at others. Suppose that in fact the numbers employed at the 
whole ten from day to day range from a minimum of 700 to a maximum of 
800. These daily numbers, whatever they are, will give the numbers of 
“regular” and “reserve” labourers who may theoretically find work at the 
whole ten wharves taken together. They must be taken as unalterable, 
determined solely by the necessary irregularities of trade and tide. They 
would presumably be the actual numbers employed supposing all the ten 
were amalgamated into a single wharf having the same mass and flow of 
custom. But so long as the wharves remain distinct, the number of indi¬ 
viduals who will practically be required to do the same work is affected also 
by quite a different set of considerations. It is clear that if each separate 
wharf forms an absolutely distinct labour market so that no man works 
at more than one, then, however the variations of business neutralise one 
another, the number of individuals required to do the work will be 100 for 
each wharf or 1,000 in all. It is clear, on the other hand, that if the whole 
ten form a single labour market within which labour is absolutely fluid, 
then the full number of individuals required will coincide with the maximum 
of 800 employed on any one day. The total number of men practically 
required to do the work without delay (and by consequence the number of 
reserve labourers) is, in fact, increased by every barrier to free movement 
from one wharf to another, and can be correspondingly decreased by every¬ 
thing tending to the organisation of the whole ten into a single labour 
market. 

The greatest barrier to free movement in any area is ignorance among 
the men as to the demand for labour in different directions; every means 
taken to remove this ignorance enables the work of any area to be done with 


24 


RISK AND RISK-BEARING 


a smaller reserve of labour. But the general distribution of the most 
accurate information as to the amount of work at each centre is only a 
first step. Even if every man knows exactly how many men will be wanted 
next day at each wharf, this will not of itself (i.e., unless each knows also 
exactly how his fellows will act) prevent too many individuals from applying 
at one wharf and (perhaps) too few at another. If it is desired to do the work 
with the smallest possible reserve of labour, some means must be adopted 
for directing the right number of specified individuals to each wharf from 
some one centre or exchange. 

The foregoing arguments may now be summarised. For the work of 
a group of casual employers a certain theoretically determinable number of 
men may be regarded as necessary; the number will be fixed by conditions 
of trade which must be taken for the present as unalterable. And, in so 
far as these trade conditions involve rapid and irregular variations of work 
within fairly definable limits, a part of this total number will have the 
character of an inevitable reserve of partially employed labour. But the 
actual number of men by whom the work is done, and its relation to the 
theoretically necessary number, will be affected also by another set of con¬ 
siderations, quite unconnected with the total volume of work or the unalter¬ 
able conditions of trade. In the first place, every hindrance to the perfect 
fluidity of labour from centre to centre will swell the actual number of indi¬ 
viduals doing the work by an amount representing the degree of friction. 
To return to the numerical instance, the work of ten w'harves, which, if 
they had become for purposes of employment one wharf, might have been 
done by 800 men, would with a certain degree of friction, require the services 
of 900. In that case there would, even when the wharves, as a whole, were 
busiest, be at least 100 men out of work. 

Those men who will in practice be added to the theoretical maximum 
for any area by friction between its separate centres, though the product of 
disorganisation are true reserve of labour without which, given that degree 
of disorganisation and friction, the industry could not be carried on. 1 

It will be noted in the foregoing argument that the problem is not 
solved by distributing accurate information as to the amount of work. 
What each will do is for the individual to determine. If one is to do 
this with scientific accuracy, it is necessary for him to know what 
every other laborer is going to do and, of course, it is equally important 
for every other laborer to know what the first laborer is going to do. 
If each man’s decisions depend upon other men’s conduct it is 
obviously impossible to eliminate a large amount of uncertainty by 
any conceivable system of information. The only way to eliminate 

1 Adapted by permission from W. H. Beveridge, Unemployment , pp. 68-81. 
(Longmans, Green & Co., New York, 1910.) 


WAYS OF DEALING WITH RISK: ELIMINATION 


25 


this element of uncertainty is to establish some central agency to 
apportion the labor in accordance with some agreed standard of 
proper distribution. , 

Exactly the same analysis applies to every other form of competi¬ 
tion. So long as we actually have competition, one large element of 
uncertainty can never be eliminated. No matter how accurate the 
business man’s information as to the prospects in a new field, his 
decision to enter that field involves a large element of risk, unless he 
knows how many other people are contemplating the same oppor¬ 
tunity and how many of them will finally decide to enter the field. 
Under present conditions this often is not difficult, for few may know 
of the opportunity, but the more widespread the dissemination of 
information, and the more general the disposal to act upon the informa¬ 
tion relative to new opportunities, the more likely is any such oppor¬ 
tunity to be “ overexploited.” In other words, the only way to 
eliminate this risk is to provide some central agency through which 
the tasks of business men may be cleared and by which their efforts 
may be apportioned in some rational way. 

Assume a given population and a given amount of labor to be 
performed, it is obvious that the only alternatives are first, a more or 
less random distribution of the employment, or second, complete 
employment for some and unemployment for others, or third, a 
rationing of labor so that each shall get part-time employment. This 
still leaves unanswered one fundamental question: Why does the 
volume of employment remain smaller than the available supply of 
labor ? Why, if there are unemployed reserves of labor, does it not 
pay someone to start new enterprises to take up this slack? For 
apparently, it must be possible to employ the men in such a way 
that they can be paid more than they can get doing nothing, and 
still leave some profit to the employer . 1 

The difficulty seems to be this: that entrepreneurs hesitate to 
make investments in industries unless they have a reasonable assur¬ 
ance of being able to get a sufficient supply of labor to keep the capital 
busy, and the exact amount to be needed is always a matter of 
uncertainty. Hence, with any given supply of labor, the extension 
of industry will be likely to stop at a point where something less than 

1 It should be noted that the question involved here is not the question of 
earning even a living wage, for if there are more laborers than can be employed at 
a living wage, it would still be profitable to employ them at one-half a living wage, 
which is better in most men’s estimation than nothing. 


26 


RISK AND RISK-BEARING 


full-time employment for ioo per cent of the people is afforded. In 
the case of the dock laborers, a supply of labor only sufficient to keep 
the docks busy in a season of minimum demand would mean that the 
docks would be undermanned at busier seasons. Docks simply will 
not be built up to that point, or if, through error, they are so built, 
they may be operated, but will be allowed to depreciate. Apply this 
line of reasoning to industry at large. One of the factors with which the 
average business man must deal is the possibility of securing labor. 
If the labor in the vicinity is already 95 per cent employed, he is 
much less likely to start a new enterprise than if it is only 90 per cent 
employed. If the labor is already 99 per cent employed, no enter¬ 
prise can start unless the income in sight is sufficient to enable it to 
draw away its labor from industries already existing. The result of 
starting such an enterprise may be to reduce the percentage of 
unemployment temporarily to zero, but such a situation cannot 
persist. The new enterprise may succeed, but its success would 
necessitate the failure or curtailment of operations of concerns which 
were in a weaker position and could not count on drawing their labor 
supply away from others. There must he some reserve for contingencies. 
Operations cannot be expanded permanently to the point where they 
require all the available supply of labor and leave no surplus to be 
drawn upon in case of emergency. 1 

The situation in industries is similar in this respect to that which 
exists in a military campaign. It is never possible to have all the 
men on the firing line at once. Quite apart from the necessity of 
utilizing part of the forces in auxiliary functions and the constant 
presence of a hospital reserve, a considerable proportion of the troops 
available for active service must always be held back to provide for 
unexpected contingencies. Only an overwhelming catastrophe or its 
imminent prospect will call into action the total available forces. 

Closely related to the method of combination to reduce risk is the method 
of compensation , by which we mean the adjustment of business affairs 
in such a way that losses of a given kind will be directly associated 
with profits of another kind. This differs from combination in that 
it does not rely upon the operation of chance to even out fluctuations 
but seeks to match one fluctuation directly against another. Planting 

1 Thus, during the boom of 1919, new industries were started without any 
source for their labor supply except labor already employed, but the resulting 
“tightness” of the labor situation was a major factor in undermining the profits of 
industry and shortening the boom. 


WAYS OF DEALING WITH RISK: ELIMINATION 


27 


a dry-weather and a wet-weather crop in the same year is an illustra¬ 
tion. Hedging contracts (see chap, xii) combine the method of com¬ 
pensation with the transfer of risk to specialists. 

NOTE I 

THE MATHEMATICS OF PROBABILITY 

In connection with the elimination of risk by combination and the 
estimation of degrees of risk, frequent reference is made to the calculation 
of probabilities. It seems necessary, therefore, to consider somewhat in 
detail what is involved in the discussion of probability in mathematical terms. 

As is brought out more fully in chapter iii, probabilities are of three 
classes: those in which a definite mathematical expression of probability 
can be attained in advance of the occurrence of the uncertain event; those 
in which such a probability cannot be known definitely in advance, but can 
be established from the observation of regularity in the past behavior of the 
phenomenon; and questions of judgment, in which neither a mathematical 
nor a statistical basis of calculation exists. We are not concerned at this 
point with the cases of judgment (which are discussed in chapter iii). 

Mathematical probabilities are expressed accurately, and statistical 
probabilities approximately, by the use of common fractions. A probability 
of 4, for instance, means, loosely speaking, that the event in question is 
likely to happen once in six “trials.” More accurately this means either 
that there are six equally probable situations, one of which constitutes the 
event whose probability we are measuring, or else that the number of 
equally probable cases is 6 n, n of which are classified together, any one of 
these n constituting the event whose probability we are trying to state. 
Thus, if in drawing cards from a full pack we estimate that our chance of 
drawing a ten-spot is A, what we mean is that there are 52 equally probable 
events, 4 of which we classify as “drawing a ten-spot,” and 48 of which we 
classify as “failing to draw a ten-spot.” All statements of probability in 
exact mathematical terms reduce themselves to classifications of equally 
probable events, part of which fall within and part without a given category, 
and comparing the number of those within with those without the category. 

Once this idea is understood, the mathematics of probability resolves 
itself into a consideration of mathematical devices for simplifying the task 
of enumerating alternatives within or without the categories in which we 
are interested. Into the intricacies of probability mathematics we need 
not proceed far; one or two illustrations will suffice to illustrate certain 
principles which we need to use. 

In many cases the probability of a given combination, in a series where 
each result is one of two equally probable events, is calculated by the use 
of the familiar binomial theorem: 




(n— i)a n 2 b 2 , n{n — 1 ) (n — 2 )a n 3 b 3 


n 




28 


RISK AND RISK-BEARING 


If the exponents are taken to represent the number of times that each item 
occurs in the combination whose probability is sought, the probability will 
be represented by the fraction whose numerator is the corresponding 
coefficient and whose denominator is 2 raised to the «th power. For 
instance, the chance of throwing heads seven times in succession is found 
by taking as the numerator of the probability fraction the coefficient of 
a 7 ; in this case unity. Taking 2 7 as the denominator, we get tTs as the 
result. The fourth term of ( a-\-b ) 7 is 35 a* b 3 ; the chances of an individual 
in seven trials throwing four heads and three tails is t 3 ^. 

The reason for the relationship between the binominal theorem and the 
calculus of probabilities will be obvious on a moment’s consideration of the 
way in which the result given in the theorem is reached through actual 
multiplication. In multiplying out, there is only one combination of seven 
a’ s; there are 35 combinations of four a’ s and three b’s, such as abababa; 
aaabbba, etc. Likewise in tossing the coin there is only one way in which 
seven heads can be tossed in succession, while there are 35 ways in which 
seven tosses can yield four heads and three tails. In other w T ords, there are 
128 distinct equally probable results, 35 of which are classified together as 
“four heads and three tails.” 

The probability of a given combination in a series of events each of which 
is one of three equally probable events, is similarly calculable by using the 
coefficients of (a-\-b-{-c) n to obtain the desired numerator, and 3” as the 
denominator. 

The combined probability of two independent and mutually exclusive 
events, that is, the probability of their both happening, is the product of 
the ratios of their separate probabilities. For instance, if the chance of a 
certain event is £ and the chance of another is the chance of both happening 
is |, provided that the occurrence of the one does not change the probability 
of the other, and also provided that they cannot both happen as the result 
of the same outside event. The chance that one or the other will happen 
is the sum of their respective probabilities, minus the probability of both 
happening. The chance that neither will happen is the product of the 
separate probabilities that each will not happen. 

For example, if the probability of A’s failure within 60 days is estimated 
as one chance in 100, and the chance of B’s failure is rated as one chance in 
200, B’s indorsement on A’s note would reduce the probability that the holder 
of the notes may suffer a loss on account of bankruptcy to one chance in 
20,000, provided neither A nor B was a customer of the other, or involved 
in business relations with the other so that the failure of one would greatly 
increase the probability of the failure of the other, and provided that their 
businesses were so different that they could not both be overthrown by a 
single independent cause. In practice, of course, the hazard of A’s failure 
is never entirely independent of the hazard of B’s failure. Modern business 
is so interdependent that the events which cause disaster to one business 



WAYS OF DEALING WITH RISK: ELIMINATION 


29 


are likely to cause disaster to many others. Wars, financial panics, changes 
in taxation, new inventions, all illustrate the extent to which the hazard 
of businesses in a single community and even throughout the civilized world 
are interdependent. 

The most important practical consequence of the theory of mathematical 
probability is the support it gives to the empirical “law of large numbers.” 
It has long been observed that many phenomena which display a high degree 
of irregularity, so far as the individual items are concerned, are highly 
regular after observation is fixed on the behavior of groups of such items. 
Thus we may be quite sure that we can predict within 30 per cent the amount 
of rainfall which will occur in a given region in the next year, while if we 
try to predict the precipitation for any particular day, it is more likely 
than not that the actual result will be either less than 10 per cent or more 
than 1,000 per cent of our estimate. So with death rates, marriages, 
enrolments in colleges, desertions from the army, accidents due to fireworks, 
and thousands of other contingencies. A single event defies prediction, 
but the mass remains always practically the same or varies in ways which 
we can predict. 

An examination of the coefficients secured by use of the binomial 
theorem show r s that so far as mathematical probabilities are concerned, the 
law of large numbers has a sound scientific basis. For example, compare 
the coefficients secured by raising (a+6) to the seventh power with those 
secured by raising (a-f b) to the eleventh power. In the first case the sum 
of the coefficients of the first two and last two terms is 16. The sum of the 
coefficients of the middle four terms is 112. That shows that the chance 
of securing as many as six heads or as few as one head out of seven trials 
is or i. If we take a similar result for the eleventh power, the sum 
of the coefficients of the first three and last three terms is 134, while the sum 
of the coefficients of the middle six terms is 1,910. That is, the chance of 
getting as few as two or as many as nine heads out of eleven trials is 134 
out of 2,044, or about one in 15. As we increase the number of terms the 
probability of a wide divergence of the actual from the most frequent 
result declines rapidly; hence more accurate prediction becomes possible. 
In tossing a coin 32 times there is only one chance in 4,500 of getting 27 
heads or 27 tails; in tossing 500 times the probability that the number of 
heads will be between 200 and 300 is nearly 1,000 to 1. 

Calculations of mathematical probability are seldom of much importance 
in actual business. Actuaries make extensive use of mathematical proba¬ 
bility in determining the cost of specific clauses in insurance policies. In 
this case the original probabilities of death or survival are not mathematical 
probabilities. They are merely statistical frequencies, but once these 
ratios are assumed, they may be treated as though they were mathematical 
probabilities. For example, in computing the premium for a policy which is 
written to be payable at the death of one or the other of two persons, the 


30 


RISK AND RISK-BEARING 


calculation of combined probability of death within a given period is a 
purely mathematical problem similar to those discussed above, once the 
mortality table is adopted. The separate probabilities rest on the observa¬ 
tion of past mortality, which it is assumed will continue. 

This assumption of continued regularity is itself a corollary of the law of 
large numbers. If we are proposing to send out 50,000 advertising letters 
to popularize a new device, we are very much interested in knowing in 
advance what proportion of the persons to whom these letters are sent 
will be likely to respond. There is no a priori method of calculating the 
probability of a given individual’s answering such a letter. Resort must be 
had to what, in the terminology of statistics, is called the sampling process. 
If we send out, say, ten letters and get three replies, we have some slight 
basis for judging what is the probability of the average prospect’s answering. 
If we send out 100 letters and get 30 replies, we have a surer basis of judg¬ 
ment. If we send out 5,000 letters to prospects taken at random from the 
list, we consider ourselves justified in assuming that the ratio of replies 
received to the 5,000 letters is very" close to that which will be shown by 
sending out the entire 50,000. The basis of this assumption is exactly the 
same as the basis for the assumption that when coins are tossed a large 
number of times there will by an approximate equality between the number 
of heads and number of tails shown. We do not know what the final ratio 
of answers is to be, but we assume that whatever the ratio is for the entire 
group, the ratio for a group of 5,000 will not diverge widely from it. The 
high degree of success which has attended the use of this sampling method 
in such widely divergent fields as market research, heredity, weather 
forecasting, and the transmission of disease, makes it apparent that there is 
some force at work establishing regularity of recurrence among many 
phenomena where inspection of a few cases seems to indicate absolute 
unintelligibility. 

Presumably the situation here is the same as it w r as in the cases of pure 
mathematical probability discussed before. That is, there is an inconceiv¬ 
ably large number of equally probable cases, part of which fall within the 
scope of one of our classifications and part within the other, and though we 
cannot calculate in advance what the ratio is, it is perfectly sound scientific 
method to infer a law from a regularity running through a large number 
of cases and use it as a basis of prediction with regard to the rest. This 
tendency of groups to display variations in their membership in definite 
ways is the basis of all social science. The economist recognizes that there 
are individuals who display no acquisitive bent, but he knows also that 
in any large group such individuals are in a small minority, and he bases 
his theory of value on the assumption that the controlling majority in any 
given case will act as controlling majorities have always acted, and that the 
abnormalities, that is, the infrequent variations, may be neglected. So 
with the educator, the practical politician, and the penologist; each recog- 


WAYS OF DEALING WITH RISK: ELIMINATION 


31 


nizes that he is dealing with individuals whose behavior is in large measure 
unpredictable, and makes no pretense of being able to offer generalizations 
or prescribed rules of discipline which will work well in each individual 
case, but he does claim to be able to develop, from experience and study, a 
program which will achieve predictable results in a large and fairly definite 
percentage of cases. 

QUESTIONS 

1. Illustrate risk being reduced (1) by increasing our knowledge of the . 
future; (2) by employing safeguards; (3) by insurance; (4) by specu¬ 
lative contracts; (5) by social control. 

2. Is it possible by foresight and calculation to reduce or to avoid some of 
the risks of industry ? All of the risks of industry ? 

3. Does integration reduce risk ? 

4. Is the collection of statistics by trade journals a co-operative or a 
specialized method of reducing risk ? 

5. Why should not the government undertake research in manufacture on 
the same scale as in agriculture ? 

6. “A strong tendency shows itself for risky enterprises to be carried on 
by large scale methods.” Why? Cite illustrations. Can you cite 
illustrations of the opposite character ? 

7. Should a large insurance company be able to give better rates than a 
small one ? 

8. How does incorporation aid in lessening risk? Does the feature of 
limited liability reduce risk or merely transfer it ? 

9. Specifically, what inconveniences would business men suffer if the 
reserve of unemployed labor were eliminated ? 


CHAPTER III 


WAYS OF DEALING WITH RISK: TRANSFER 
TO OTHERS; ASSUMPTION OF RISK 

The methods outlined in the preceding chapter are not adequate to 
remove nearly all of the uncertainties of production, and consequently 
it is necessary for someone to bear the risks which are not so removed. 
It is not necessary, however, that the brunt of this risk-bearing should 
be borne by the individuals upon whom it falls in the first instance. 
Here, as elsewhere, in modern business the principle of specialization 
has been found useful, and much of the complexity of our industrial 
and commercial system is the result of attempts to relocate the burden 
of risk. Usually the transfer is combined with some other method 
of risk reduction. Frequently, for example, specialization in risk¬ 
bearing is associated with the reduction of risk through combination, 
as is the case in most insurance. The fire insurance company, for 
instance, by insuring a large number of houses in scattered localities, 
changes the small risk of a ioo per cent loss into the practical certainty 
of a small loss; hence the transfer of the risk is a social gain. Some¬ 
times a transfer results in risk reduction through more successful 
forecasting on the part of the specialist. For example, an investment 
bank is able to assume the risks connected with floating new bond 
issues better than can many borrowing corporations in part, because 
of its special expertness in judging market conditions, hence assumes 
the risk by underwriting the issues, i.e., guaranteeing their success . 1 
Sometimes transfer is associated with prevention, as when a company 
insuring steam boilers provides an inspection service designed to pre¬ 
vent explosions, or a life insurance company contributes to the support 
of a public nurse. Occasionally the transfer results merely in a 
transfer of the risk to someone better able, or more willing, to bear 
it, as is the case in most speculative contracts. 

For purposes of discussion it is convenient to divide the subject 
of risk reduction through transfer into three principal topics: The 
specialization of business men as a class in carrying the risks of ordinary 

1 There is also some combination of risk involved in this transfer, and sometimes 
some prevention , if the underwriter undertakes the active management of the 
selling. 


32 


WAYS OF DEALING WITH RISK: TRANSFER 


33 


business, which forms the subject-matter of the remainder of this 
chapter; the specialization of investors in carrying various kinds and 
degrees of risk, discussed in chapters vii to xi, and the organization 
of special agencies for shifting special types of risk, which are dealt 
with in chapters iv and xii to xvi. 

The typical organization of modern business involves specialization 
in risk-bearing. The ordinary relationship between employer and 
employee, between borrower and lender, may not appear, at first 
glance, to illustrate the transfer of risk, but a moment’s reflection will 
show that that is exactly what its purpose is. When a business is 
organized, the owner of the business, his creditors, and his employees 
enter into a co-operative scheme for carrying on production, each 
specializing in furnishing certain services. The labor group furnish 
their time, skill, and energy. The capitalist-lender furnishes the use 
of his capital. The owner furnishes part of the capital and part of 
the time and skill, and assumes the responsibility for determining 
the fundamental policies of the business. The risk is divided between 
them. The laborer assumes most of the risks of physical harm, which 
arise in the processes of production, though the modern tendency is 
to transfer the financial hazard of accidents in large part to the 
employer. The laborer also assumes the risk that if the enterprise 
is unsuccessful, or if it develops in such a way that his services are no 
longer needed, he will find himself left without employment. The 
capitalist-lender subjects his investments to the hazard of complete 
loss if the business proves so unsuccessful that the entire capital 
invested in the business is sunk so that the loans cannot be repaid. 

The owner-manager assumes the risk of failure just so far as his 
resources are sufficient to cover that risk. He is the primary risk 
bearer; if financial loss falls on the others, it is chiefly because he evades 
or is unable to meet, his responsibility. In meeting this responsi¬ 
bility, the owner-manager has a large measure of freedom of choice 
of methods. As was pointed out in chapter ii, he finds it advantageous 
to undertake research in order to reduce the range of uncertainty 
with which he has to deal. He may transfer a part of his burden to 
specialists. Certain risks, however, he must assume, and others he 
is likely to assume. 

It will be noted that the form in which the risk of business falls 
upon the owner-manager is essentially different from the way in 
which the risk falls upon the other members of the co-operating 
organization. So long as the system functions in the way it is intended 


34 


RISK AND RISK-BEARING 


to function, the product of any industry is divided by withdrawing 
first the shares of the laborers and the outside lenders, which are 
fixed in advance by agreement, and leaving the remainder for the 
owner-manager. The laborer who puts his time into a given pro¬ 
ductive process is guaranteed a certain wage and is entitled to that 
wage whether the enterprise succeeds or not. Likewise the capitalist 
who lends his money to the business is entitled to his interest, whether 
the enterprise succeeds or not. In theory not only the capital 
invested by the owner but any other resources which he may have 
must be exhausted before the loss, in case of failure, can properly 
be assessed upon the co-operating capitalists and wageworkers. 
The risk which falls upon the latter groups, therefore, is relatively 
remote, and losses fall upon them only in case the owner-manager, 
who is responsible for carrying the risks of the business, is unable to 
meet his responsibility. 1 The return of the owner-manager, on the 
other hand, is subject to the entire risk of the business. This is true 
in the nature of the case not only of those businesses where there is 
real risk of failure, but also in cases where success is practically assured, 
for it is almost never true that the exact amount of the total income 
of the business is known in advance, and whatever uncertainty exists 
is concentrated upon the share of the owner-manager. As a result 
the share of the owner-manager has a much wider proportionate range 
of fluctuation than does the income of the business as a whole. If, 
for instance, the gross income of a business varies from $800 to $1,200, 
and the interest and wage bills absorb $600, the income of the owner- 
manager will fluctuate from $200 to $600. A variability of 50 per 
cent in the income of the enterprise results in a variability of 300 
per cent in the owner’s share. 

This is the characteristic which distinguishes profit, on the one 
hand, from wages and interest, on the other. Profit is known only 
as the results of the undertaking become evident, and fluctuates with 
every factor which changes those results, while wages and interest, 
whether paid to outsiders or “imputed” to the owner’s own labor 
and capital, are determined in some way in advance. It follows, of 
course, that in a given case the profit may turn out to be a minus 
quantity. If the return of the enterprise falls short of the interest 
and wages agreed upon, the difference is called a “loss” instead of a 
profit. 

1 The necessary qualifications of this statement, with reference to corporations 
and limited partnerships and other cases of limited liability, are discussed below, 
chap, xviii. 


WAYS OF DEALING WITH RISK: TRANSFER 


35 


Whether business enterprise, as a whole, yields an average profit 
or an average loss is an open question. The traditional economic 
view is that both profit and loss tend to disappear. Under free 
competition, capital and labor tend to flow into the most profitable 
openings that are available and to move out of the unprofitable. 
Given time enough and knowledge enough, any opportunity wherein 
the return remains much ab< 5 ve the market value of the resources 
which it utilizes will draw to itself such a volume of capital and labor 
that the return to capital in it will be lowered to, or below, the normal 
rate by the ordinary effect of competition, and in any enterprises 
where the return is below normal, capital will flow out until the reduced 
volume of production brings the return up to normal. This process 
is never complete, because new inequalities are constantly appearing 
as old inequalities are being flattened out. The process is like the 
-processes by which the surface of the sea seeks its level. No one 
ever saw the sea level, yet at every moment the crests of the waves 
are being flattened and the troughs filled through the ceaseless opera¬ 
tion of the force of gravity. In like manner the crests of profits and 
the troughs of loss are being flattened out by the force of competition. 
The concept of the normal return is used just as is the concept of the 
sea level as a base line from which to measure deviations, not as a 
description of the condition existing at any moment. The hope of 
profit is the inducement to incur a risk, and the result of the attempt 
to secure profit is to destroy the opportunity to do so. Hence, 
profit consists of a series of temporary returns, not a continuous flow 
of income. 

This analysis holds good, however, only so far as the uncertainty 
which makes profit possible actually does disappear. As Cliffe Leslie 
pointed out many years ago, the operation of such a tendency is 
contingent upon the assumption that the conditions of profit and loss 
become known, an assumption to which exceptions are innumerable: 

The full knowledge and foreknowledge lately claimed for political 
economy in modern commercial society can exist only at an opposite state 
of development, at which human business and conduct are determined, 
not by individual choice, or the pursuit of wealth, or commercial principles, 
but by immemorial ancestral custom. All that relates to the occupations 
and movements of a nomad tribe in Central Asia is known and foreknown 
by all its members. At the more advanced states of early agricultural 
society the power of prediction continues. Dynasties rise and fall, con¬ 
querors come and go, empires are shattered above the head of the village 
community; yet it survives unchanged. 



36 


RISK AND RISK-BEARING 


But just in proportion as the stationary passes into the progressive 
condition, as industry and commerce are developed, does the social economy 
become complex, diversified, changeful, uncertain, unpredictable, and hard 
to know, even in its existing phase, at any given time. In the primitive 
village community the prices of commodities and the gains of producers 
are not only known, but foreknown, because they are customary prices. 
But when a market grows upon the border, when dealings with strangers 
are unrestricted by the tie of kinship or community, or by usage, the prices 
at which things are bought and sold can no longer be known beforehand, 
and are not even necessarily known to everyone afterwards. Production 
can no longer be exactly adjusted to consumption, supply to demand, both 
the number and the means of customers from without being unknown. 
And as industrial development proceeds; as labour is subdivided, and 
occupations multiply, and the methods of production improve; as commerce 
enlarges its borders and changes its paths, the unknown more and more 
takes the place of the known. The desire of wealth, or of its representative 
—money—instead of enabling the economist to foretell values and prices, 
destroys the power of prediction that formerly existed, because it is the 
mainspring of industrial and commercial activity and progress, of infinite 
variety and incessant alteration in the structure and operations of the 
economic world. 

Just as from the strength of the impulses to marriage, together with 
observations of their consequences, you may predict that, other circum¬ 
stances remaining the same, nearly the same number of young men in busi¬ 
ness will marry this year as last; so from the strength in this country of 
pecuniary interest, and the course of conduct it has been found for centuries 
to lead to, you may predict that, if business does not greatly fall off, about 
the same number of young men will go into it this year as last. But you 
can no more predict from their love of money what prices and profits the 
young men will get in their business than from their love of fair women 
what fortune they will get with their wives. And you might as well assume 
that, allowing for difference of age, looks, and family, and other attractions, 
the fortunes the wives bring will be equal, as that, allowing, according to 
the orthodox formula, for differences in the nature of their employment, 
they will make equal rates of profit on their capital. Here the real main 
postulate of the deductive economist comes in. They cannot, he says, 
make a higher rate of profit in one business than in another, because other 
people will not allow that if they know it, but will cut in at once. And he 
assumes that they do know it. He assumes that the choice of occupations 
and investments, and the movements of labour and capital, are determined 
by knowledge so accurate that the result is the same percentage of profit 
on capital all round, and a scale of comparative prices in proportion to the 
quantity and quality of the labour and sacrifices required to produce 
commodities, or their comparative cost of production. 



WAYS OF DEALING WITH RISK: TRANSFER 


37 


Even in a modern village the innkeeper, publican or shopkeeper, who 
is making a small fortune, does not invite competition by telling his neigh¬ 
bours of his profits; and the man who is not doing well does not alarm his 
creditors by exposing the state of his affairs. If you take a whole country 
like England, it becomes a matter of accident, situation, and personal 
history and connexion, what a man knows about the state of any particular 
business. 

In both home trade and international trade the migration of labour 
and capital has some effect on wages and profits, and the comparative cost 
of producing different commodities some effect on their comparative value 
and price; but, in both cases the effect is uncertain, irregular, and incalcu¬ 
lable. In neither case is there an equalization of either wages or profits. 
If a particular business is known or believed to be flourishing, capital 
flow T s into it; but it also flows into businesses that are, in reality, very 
unprosperous. One has only to keep one’s eyes open in the streets of 
London to see, year after year, 'fchops fail, disappear, and reappear with 
another name over the window, though the locality evidently does not 
support them. Save in so far as the prosperity of their own business 
depends on that of others, the people in one trade know little or nothing 
of the condition of other trades, or no more than the newspapers tell them. 

In truth, the choice of employment runs in a very narrow groove. 
There is, no doubt, a tendency of trades to localize themselves, like cotton 
manufacture in Lancashire, in the places with the best natural aptitudes for 
them. But in the degree and manner in which this localization takes place 
it is largely the result of want of information, and want of originality and 
enterprise, and is far from effecting the best distribution of industry. Men 
follow each other, like sheep, in flocks, though the sheep are not wise in 
inferring that wherever there is enough good grass for a few, there must 
be plenty for the whole flock that goes after them. 1 

So much may be said for the doctrine that profits tend to dis¬ 
appear. Other students believe that there is a tendency to a perma¬ 
nent positive return, not received by all business men but received by 
the average business man, and constituting the reward of the owner- 
manager group as a whole for the service of risk-bearing. Their 
reasons for this belief may be stated as follows: Of two opportunities, 
if one offers a certain return of 6 per cent, while the other may yield 
anywhere from nothing to 12 per cent, the former is the more attrac¬ 
tive. Other things being equal, people prefer to put their capital into 
enterprises which offer the certainty of a given return rather than 
into those which offer a probability of the same return but no certainty. 

1 Adapted from Thomas E. C. Leslie, “The Known and the Unknown in the 
Economic World,” Fortnightly Review , XXXI (1879), pp. 934-49. 


38 


RISK AND RISK-BEARING 


Hence, doubtful enterprises do not attract capital in sufficiently 
large quantity to bring the return in them down to the same average 
level as in safe enterprises, but only down to the level where the 
most probable difference is sufficient to overcome the disinclination 
to incur risk. Profit is therefore a permanent and necessary part of 
the social dividend and is accounted for as the only incentive to render 
the service of “ uncertainty bearing,” which is as essential a service 
as that of saving capital or doing work. 

This reasoning is probably correct, at least for certain types of 
risk, but it is by no means conclusive. It is clear that the hope of 
profit is the incentive leading men to put their capital at risk rather 
than to put it in safe investments, but it does not necessarily follow 
that speculative enterprises as a whole must necessarily return a 
profit to their owners. It is only necessary that there be a sufficient 
number of successful enterprises to keep the hope of profit alive. 
Some men, indeed, are so conservative and cautious that they must 
have, not only the possibility, but a high probability of a return 
before subjecting their capital to unnecessary risk, but the necessity 
of society’s paying profit to business men does not rest upon the 
cautiousness of the most cautious or even the average man. All 
that is necessary is that for enterprises with a given degree of risk 
there shall be a sufficient prospective profit to attract thither the 
capital of those individuals who are least concerned about risk (or 
those for whom the risk is least), in sufficient numbers to exploit 
the opportunity. And it is by no means certain that for business 
enterprises as a whole this necessitates a positive level of profit. 
Certainly there are many enterprises in which society is served by 
uncompensated risk-bearers. Prospecting for gold is generally 
believed to be a case in point, and developing new inventions is 
probably another. 

Many men are disposed to underrate risk where their own interests 
are involved, and society reaps the benefit of their error. Adam 
Smith’s observations on this point are as sound today as they were 
in 1776 : x 

That the chance of gain is naturally over-valued, we may learn from 
the universal success of lotteries. The world neither ever saw, nor ever 
will see, a perfectly fair lottery; or one in which the whole gain compensated 
the whole loss; because the undertaker could make nothing by it. In the 

1 For a qualification, however, cf. chap. vii. 


WAYS OF DEALING WITH RISK: TRANSFER 


39 


state lotteries the tickets are really not worth the price which is paid by 
the original subscribers, and yet commonly sell in the market for twenty, 
thirty, and sometimes forty per cent advance. The vain hope of gaining 
some of the great prizes is the sole cause of this demand. The soberest 
people scarce look upon it as a folly to pay a small sum for the chance of 
gaining ten or twenty thousand pounds; though they know that even that 
small sum is perhaps twenty or thirty per cent more than the chance is 
worth. In a lottery in which no prize exceeded twenty pounds, though in 
other respects it approached much nearer to a perfectly fair one than the 
common state lotteries, there would not be the same demand for tickets. 
In order to have a better chance for some of the great prizes, some people 
purchase several tickets, and others, small share in a still greater number. 
There is not, however, a more certain proposition in mathematics than that 
the more tickets you adventure upon, the more likely you are to be a loser. 
Adventure upon all the tickets in the lottery, and you lose for certain; 
and the greater the number of your tickets the nearer you approach this 
certainty. 

The contempt of risk and the presumptuous hope of success are in no 
period of life more active than at the age at which young people choose 
their professions. How little the fear of misfortune is then capable of 
balancing the hope of good luck appears still more evidently in the readiness 
of the common people to enlist as soldiers, or to go to sea, than in the 
eagerness of those of better fashion to enter into what are called the liberal 
professions. 

In all the different employments of stock, the ordinary rate of profit varies 
more or less with the certainty or uncertainty of the returns. These are 
in general less uncertain in the inland than in foreign trade, and in some 
branches of foreign trade than in others; in the trade to North America, for 
example, than in that to Jamaica. The ordinary rate of profit always rises 
more or less with the risk. It does not, however, seem to rise in proportion 
to it, or so as to compensate it completely. Bankruptcies are most frequent 
in the most hazardous trades. The most hazardous of all trades, that of a 
smuggler, though when the adventure succeeds it is likewise the most 
profitable, is the infallible road to bankruptcy. The presumptuous hope 
of success seems to act here as upon all other occasions, and to entice so 
many adventurers into those hazardous trades, that their competition 
reduces their profit below what is sufficient to compensate the risk. To 
compensate it completely, the common returns ought, over and above 
the ordinary profits of stock, not only to make up for all occasional losses, 
but to afford a surplus profit to the adventurers of the same nature with 
the profit of insurers. But if the common returns were sufficient for all this, 
bankruptcies would not be more frequent in these than in other trades. 1 

1 Smith, Wealth of Nations , Book I, chap. x. 


40 


RISK AND RISK-BEARING 


The common statement that profit is the “reward” of risk¬ 
bearing means simply that the hope of profit is the inducement which 
leads men to incur the risk of a loss, not that the profit actually 
attained in a given case bears a predictable relation to the amount of 
risk actually undergone in that case. Obviously there is no conscious 
purpose on anybody’s part to “reward” the risk-taker. 

The only way in which risk enables an individual to secure a 
profit is by its tendency to keep others out of the field. What we 
have to deal with is a constant shifting of capital from one field to 
another in the effort to secure the maximum return for individual 
owners. The greater the number of capitalists who strive to enter 
a given field, the less the prospect of profit from investment in that 
field, and the less the risk the greater that number is likely to be. 
Almost any other force which limits the amount of capital available 
for investment in a particular line may give rise to profit in the same 
way. The only reason economists have fixed upon risk as the source 
of profit is its frequency, for if a given line of endeavor offers with 
certainty more than the market rate of interest and wages to those 
who engage in it, the other deterrents are rarely effective. If, for 
instance, we had numerous cases of high profits in certain lines caused 
by social disapproval of the enterprises, we should have to develop 
courses in odium and odium-bearing to complete our survey of the 
quest of profits. Such cases are not unknown , 1 but aside from monop¬ 
oly they are so few, comparatively speaking, that there is no material 
error in assuming that absolutely certain opportunities for getting 
more than a normal return without monopoly simply do not exist. 

This does not mean, however, that the uncertainty to be effective 
must be present in everyone’s mind, least of all in the mind of the 
profit-seeker . 2 Profits are made most successfully by those who 
know first and reap an advantage from the uncertainty in other 
men’s minds. As Hadley puts it: 

Many of the writers who treat of the relation between business risk 
and business profit make the mistake of assuming that profits are an amount 

1 Money-lending in the Middle Ages and the “white slave traffic” in modern 
times are illustrations. 

3 In this respect the relation between uncertainty and profit is similar to that 
between other elements of distribution and the services which they “reward.” 
For instance, wages may be regarded as an incentive to overcome laziness, but this 
does not mean they will be withheld from those who prefer work to leisure. They 
reward those who relieve the rest of society from overcoming its laziness. Again 
interest as the “reward of abstinence” is the due of those whose saving involves no 
conscious abstinence at all, as long as some saving involves the exercise of abstinence. 


WAYS OF DEALING WITH RISK: TRANSFER 


41 


paid to the individual capitalist to cover his risk of loss. Far from it. 
They are paid to capitalists as a class for protecting the public against its 
risk of loss. They are charges which the capitalists make, not for insuring 
themselves, but for insuring society against the losses incident to industrial 
experiment and industrial progress. 1 

Or in the words of a German economist of a generation ago: 

The entrepreneur must always to a certain extent carry risk, the risk 
of both a technical and an economic failure of production. But the signifi¬ 
cance of the risk depends on the individual. To walk on a tight rope over 
an abyss is obviously a frightfully risky thing for an ordinary mortal, but 
for a trained acrobat walking on the rope may involve no special risk at 
all. So it is with the entrepreneur. A business man versed in the technique 
of industry and commerce knows the art of keeping his balance and under¬ 
stands how to take business risks with success; it does not appear to him 
a perilous thing to establish and carry on a business, while a novice shrinks 
from the risk. 2 

To state the point more precisely, the significance of risk as a 
source of profit depends in each case on its effectiveness as a deterrent 
to competitive efforts to exploit the given opportunity, and its effec¬ 
tiveness depends on the degree of uncertainty inherent in the situation, 
the number of people to whom the probability of success appears 
great, their attitude toward the taking of risk, and the amount of 
capital they control. If the “supply of entrepreneur ability” is large 
either because the uncertainty in many people’s calculations is small 
or because a reckless attitude prevails, risky enterprises will be 
developed and the percentage of failures will be high. Whether the 
average level of profit is high or low, whether indeed it exists at all 
as a positive quantity, seems to be a question of local circumstances 
about which no general statement of value can be made . 3 

1 Economics , pp. 288-89. 

2 Klein wachter, Das Einkommen und seine Verteilung , p. 287. (Leipzig, 1896.) 

3 Cannan suggests that both very risky and very safe enterprises yield less 
than an average return because of their undue attraction for people of abnormally 
high, or abnormally low, caution. (Palgrave, Dictionary of Political Economy , 
article on “Profit.”) This conclusion seems to be verified by tentative results of 
studies of returns of stocks and bonds made under the author’s direction, but this 
evidence is not yet complete enough to warrant a positive statement. 

The statistical evidence from income studies is inadequate. King found 
{Wealth and Income of the People of the United States, p. 168) that owners of business 
made a somewhat higher return than hired laborers ($899 as compared with $507, 
in 1910), but this difference, after allowance is made for interest on invested capital, 
may be no greater than the average difference in wage-earning capacity of the two 


42 


RISK AND RISK-BEARING 


Where monopoly exists it is possible to sell goods at a price yielding 
a profit , sometimes an enormous profit above the cost incurred, 
without apparent risk. In these cases the conditions which give rise 
to monopoly—such as patent rights, terrorism, limitation of natural 
resources—operate to protect the investor from competition just as 
in the cases we have been considering risk operates to protect him. 
Whatever causes operate to check the flow of investment into a 
given industry may give rise to an opportunity for profit in it; the 
cause of the monopoly operates just as risk does, but more effectively . * 1 

The securing of monopolies is an extremely profitable business for 
the few who succeed in it. —It does not seem, however, to be more 
free from risk than any other business. The development and 
early financing of inventions is notoriously speculative. Obtaining 
franchises to establish public services may not involve much risk for a 
few whose connections enable them to do it most successfully, but 
their success is clearly conditioned on the degree of ignorance or 
uncertainty on the part of the public from whom they get the privilege, 
or of rival investors who might otherwise bid for it. 

Most sources of profit involve either monopoly or risk. —By superior 
wit and by strength of will it may be possible to buy the essentials 
of production at a price below the market, while selling at prices 
based on the full market costs, thus making extraordinary profits. 
Smuggling goods and then selling in a market where prices depend 
on competition of duty paid goods; “moonshining” whiskey and 

groups. Professor Knight has summarized the evidence and the opinions of lead¬ 
ing economists (Risk, Uncertainty, and Profit, pp. 364-66). He concludes that 
profit as a whole is negative. For a fuller summary of the scanty evidence, 
cf. Porte, Entrepreneurs et Profits industriels, pp 182-215. 

1 It should be noted that in strict logic the return which accrues to the owner 
of a monopoly, after the value of his opportunity has been definitely established, is 
really a part of his interest, not his profit. Once the amount is known which can 
be gotten out of, for instance, a patent, the patent itself has a value which capitalizes 
that‘return, and the return becomes interest on that capitalized value. The 
profit, which comprises the whole capitalized value of the patent, minus the cost 
of obtaining and developing it, arose at the time the value attached itself to the 
patent, that is, at the time uncertainty passed into certainty. (Indeed it accrued 
in part before that, for as soon as it becomes highly probable that the patent will 
have value, it acquires a value which discounts that probability.) So with other 
cases—the return from a monopoly of certain quality of land is, after all, only the 
rent of that land, no different in character from any other rent. Profit arises when 
the income producing power of the land is increased by the formation of the monop¬ 
oly, not when the higher rent is collected afterward. 



WAYS OF DEALING WITH RISK: TRANSFER 


43 


selling in a market where the tax is a main element in the market 
price, are examples. “ Outbargaining ” labor or shrewdness in securing 
capital on favorable terms works out likewise. There does not seem, 
however, to be any necessity for erecting these gains into a distinct 
distributive share or regarding them as exceptional. The question 
is always, not “What is the specific source of profit?” but “Why 
does not the competition of other managers destroy the profit in 
exploiting that source?” The cases cited all seem to resolve them¬ 
selves into cases where competition is reduced on account of risk—as 
in the smuggling industry, or into special aptitude for bargaining, 
which must be recognized in determining the wages of the bargainer, 
or into some form of monopoly. Frequently, for example, a local 
group of laborers may be exploited because only one opportunity 
for employment is accessible to them; the opportunity to profit by 
such a situation is a simple case of monopoly of location. 

Risk and control are closely associated .—In the preceding discussion 
the effect of risk on profit and on business organization has been dis¬ 
cussed on the assumption that the two functions of carrying risk and 
appropriating profit are associated with the exercise of control. The 
combination of these three elements is the root of the present system 
of industry, and is commonly referred to as the right of private prop¬ 
erty. Some of the social results of this combination and some of the 

ways in which the traditional relationship of its elements are being 

♦ 

modified are discussed in chapter xviii; our present interest is to note 
that the dominant figure in present-day industrial and commercial 
organization, the business man, owner-manager, or entrepreneur, as 
he is variously designated, owes his position to the supposed advan¬ 
tages of vesting control in those who are financially able and are 
willing to assume the risks of industry and the responsibilities of 
control for the sake of an opportunity to reap a more or less uncertain 
reward in the form of profit. We must now consider some of the quali¬ 
fications for successful entrepreneurship. 

Certain mental attitudes and characteristics are necessary for adminis¬ 
tration and operate more or less crudely to select the individuals on 
whom responsibilities of business sh^ll fall. Without attempting an 
exhaustive survey, attention may be directed to four of the qualifica¬ 
tions which seem to be most directly significant in the selection of 
business managers. The first is business judgment , the second is 
willingness to incur risk , the third is open-mindedness , the fourth is 
decision . 


44 


RISK AND RISK-BEARING 


All these qualities have to do with one’s attitude toward uncer¬ 
tainty. By judgment we mean here simply the ability to weigh the 
known elements in a situation and determine the most probable situa¬ 
tion with respect to the unknown. Willingness to incur risk involves 
several characteristics. A large element in it is confidence in one’s 
own judgment. This is something quite distinct from the ability to 
form a correct judgment. As Professor Knight says: 

.... There is diversity in conduct in situations involving uncertainty 
due to differences in the amount of confidence which individuals feel in their 
judgments when formed in their powers of execution; this degree of con¬ 
fidence is in large measure independent of the “ true value ” of the judgments 

and powers themselves.It is a familiar fact that some individuals 

want to be sure and will hardly “take chances” at all, while others like to 
work on original hypotheses and seem to prefer rather than shun uncer¬ 
tainty. It is common to see people act on assumptions in ways w T hich their 
own opinions of the value of the assumption does not warrant; there is a 
disposition to “trust in one’s luck.” 1 

Next to business judgment this quality of confidence in and willing¬ 
ness to act on one’s best judgment where certainty is absent seems to 
be the most decisive factor in determining whether one shall be among 
those who occupy positions of responsibility—indeed, so far as the 
choice of managers is concerned this factor of willingness to accept 
responsibility is perhaps more important than the ability to form 
correct judgments, though less important in determining the manager’s 
success. The other two qualifications for dealing effectively wdth 
risk, decision and open-mindedness, may seem at first to be incon¬ 
sistent with one another, but they are not. By open-mindedness we 
mean the ability and willingness to change our decision or opinion 
as soon as the appearance of new evidence makes it appear that our 
former position was wrong; by decision the ability and will to stick 
to a judgment once formed until such reason for change has actually 
appeared. Efficiency in business management, as in most responsible 
tasks, requires that one steer a middle course between two extremes. 
On the one hand, we have the vacillator, the wobbly-minded man 
who, having chosen one line of policy on a doubtful issue, cannot 
forget the alternative and is constantly reopening the issue and debat¬ 
ing the question over without any new evidence on which to decide. 
At the other extreme we have the “bullhead,” the man who, having 
chosen an alternative, sticks to it with obstinacy, refusing to be 

1 F. H. Knight, Risk, Uncertainty , and Profit , p. 242. 



WAYS OF DEALING WITH RISK: TRANSFER 


45 


influenced by new evidence which may make the grounds of his 
original choice no longer valid. There are none so blind as those who 
will not see. 

Of these qualities only the first, business judgment , needs more 
extended discussion. As indicated above, judgment means the ability 
to form a valuable conclusion in a case where the evidence does not 
suffice to establish certainty. But not all cases of uncertainty call for 
the exercise of judgment. The determining factor is not the presence 
of uncertainty but the character of the uncertainty, that is, the exact¬ 
ness with which the degree of probability is known. 

Estimates of probability fall roughly into three classes. 1 There 
are, first, a few cases where a quite definite mathematical estimate of 
probability can be reached, as, for instance, that a result will be of one 
character seven times out of a hundred, of another character ninety- 
three times. Many gambling transactions are of this sort, but 
illustrations are rare in ordinary business. The Goodyear Company, 
in 1921, issued a series of 8 per cent bonds, one-fortieth of which, 
drawn by lot, are to be paid at $120 per $100 bond every six months 
for twenty years. It is clear that the probability of an investor’s 
securing a 20 per cent bonus for the use of his money for six months, 
twelve months, or any other definite period can be figured math¬ 
ematically, and the speculative value of this chance can be computed 
with corresponding precision. No “judgment” enters into this 
calculation. 

A second and larger class of cases affords what may be called a 
statistical basis for action. These are cases where no uniformity 
of results could be predicted from the nature of the case, but study 
of past results shows that uniformities have appeared with such 
persistency that we assume they will continue to appear. This is the 
justification of most business research, as distinguished from techno¬ 
logical research. The merits of specific selling devices, specific 
methods of wage payment or organization of the labor force, or specific 
types of financial instrument cannot be judged even approximately 
by a single case; but by collecting, organizing, and studying a mass 
of representative cases results of great accuracy can be obtained. 
Here again if the evidence is sufficient to establish the degree of risk 
accurately, as it is, for instance, in many life insurance calculations, 
no exercise of judgment is involved in the estimate of probability. 

1 Cf. Knight, op. cit., pp. 214-16, 224-26. 


46 


RISK AND RISK-BEARING 


Cases of uncertainty where neither the mathematical nor the 
statistical basis of determining probability is available call for the 
exercise of what we call “judgment.” 

These are cases where the events to be feared are so rare, or the 
difficulty of forming homogeneous classes among them as a basis for 
statistical generalization is so great, that there is no adequate basis 
of experience for judging whether they will take place, or what is 
the probability of their taking place. Thus, while the probability 
that a given individual chosen at random is a thief might be tested 
statistically, the probability that a certain known individual is a thief 
is often quite unattainable. His early training, his beliefs and habits, 
his family responsibilities, his age, and a hundred other things have 
to be weighed, and there are not enough people who are alike in all 
these ways to afford a basis for a statistical study. The judgment of 
a good student of human nature on the question, nevertheless, has a 
greater value than that of a poor student, though either may be wrong 
and either may be right. 

The method by which these cases are handled, in the author’s 
opinion, is in essence a very crude application of the statistical method. 1 
That is merely another way of saying that our judgments, if they have 
any value at all, are based invariably on some sort of experience with 
similar cases, either our own experience or that of others. The cases 
from which we judge may be too few to lend themselves to statistical 
tabulation, or too widely different for comparison, but if we use them 
at all it must be through a crude, perhaps unconscious, application of 
what is essentially the same process as is employed in the statistical 
method. The difference between good judgment and bad judgment 
resolves itself into (i) a difference in the amount of data made available 
by personal experience or by education, (2) the ability to classify that 
experience so that only the relevant items enter into the judgment, 
and (3) the ability to give proper relative weight to the items which 
make it up. 

Of these the last is the most difficult. The tendency is (1) to 
overvalue one’s own experience in contrast to that of others, (2) to 
overvalue the evidence which points to a conclusion coincident with 
our own desires or interests, and (3) to overvalue the recent experience 
contrasted with that which is less fresh in our minds. To overcome 
these tendencies is to gain immensely in skill at forming judgments. 
And no one should feel chagrin if, having taken into consideration all 

1 See Note 1, at end of this chapter. 


WAYS OF DEALING WITH RISK: TRANSFER 


47 


the available data and applied his most careful judgment, the event 
proves him to have been in the wrong. No excellence of judgment can 
eliminate the sphere of uncertainty; it can only tell us what is most 
probable. If the improbable happens, the judgment of the reckless 
plunger who foretold it is not thereby vindicated nor that of the 
careful student discredited. Only average results over a period of time 
can furnish a test of skill. Herodotus states the point aptly thus: 

There is nothing more profitable for a man than to take good counsel 
with himself; for even if the event turns out contrary to one’s hope, still 
one’s decision was right, even though fortune has made it of no effect: 
whereas if a man acts contrary to good counsel, although by luck he gets 
what he had no right to expect, his decision was not any the less foolish. 1 

A more detailed survey of what is implied in the formation of a 
business judgment is given by a psychologist in the following terms: 

The conception that business acumen is an indefinable, intangible some¬ 
thing, outside the realm of educability, is widely held. Nevertheless, 
psychologists have long insisted that intellectual insight and ability, whether 
in business or in anything else, are the products of perfectly definite causes, 
in part hereditary, but in part acquired, and hence, presumably, susceptible 
in some degree to discipline. Educators have long prescribed practical 
methods for training reasoning ability in school. There would seem, there¬ 
fore, to be no good reason why schools of business administration should 
not definitely avow as one primary aim the cultivation of ability to make 
sound business judgments, even granting that it may require actual business 
experience to develop that ability to its maximum degree. 

Business judgment differs from judgment in other fields only in the 
materials with which it is concerned—business problems and business facts— 
and in certain minor details consequent upon the peculiar nature of those 
materials. In its psychological mechanisms it is not fundamentally unlike 
scientific method, or legal reasoning, or reflective thinking in any other 
field; although the frequent short-circuiting or condensing of the process, 
made possible through long practice and through familiarity with a definite 
field, into what has sometimes been called “practical judgment,” often 
obscures some of the component factors. Judgment, or reasoning, or 
reflective thinking (which terms, for our purposes, we may regard as synony¬ 
mous) may be described as essentially a complicated kind of behavior 
by means of which the individual adjusts himself to new problems pre¬ 
sented by an ever changing physical and social environment; problems 
which the ready-made adjustment mechanisms of instinct, habit, and 
memory are incapable of solving. Reasoning is made possible by the reor¬ 
ganization and re-utilization of the element of previous experience in new 

1 Quoted in Keynes, A Treatise on Probability, p. 307. 


48 


RISK AND RISK-BEARING 


forms. It is no unique operation; it involves the same mechanisms of 
associative recall and discrimination as the simpler operations of percep¬ 
tion, habit, and memory, although on a somewhat more elaborate scale, 
and is ordinarily marked by greater hesitancy and conscious purposiveness. 
The mental content in which these mechanisms find embodiment varies with 
the nature of the materials and the habits of the individual thinker. It may 
take the form of vocal or silent speech symbols, mental imagery of various 
sorts (visual, auditory, or motor, verbal, or concrete), or incipient—or 
even overt—gestures, impulses, and attitudes, although the modern psy¬ 
chologist is inclined to regard their precise character as of less significance 
than the use made of them. 

Reasoning activities vary widely, of course, in scope and complexity. 
An “act of business judgment” may denote anything from an instantaneous 
sizing-up of and acting on a relatively simple situation, to the involved 
investigations and prolonged deliberation leading up to a momentous bus¬ 
iness decision or the adoption of far-reaching business policies. Sometimes 
the basic data of the judgment are definite and complete; sometimes so 
obscure that a judgment is almost a leap in the dark, and even the shrewd 
executive cannot put his finger on the specific factors which determine his 
decision. But in all such acts we find, explicit or implicit, common factors 
and operations. Seldom is it possible to trace these as temporally distinct 
and successive stages, so varied are the modes in which they may be sub¬ 
ordinated, merged, reversed, and repeated. Nevertheless, we may con¬ 
veniently take as a point of departure for our search for ways of training 
judgment five stages or elements, corresponding in the main to those “steps” 
which Dewey 1 has made familiar to students of education. 

1. A felt difficulty 

2. Its location and definition 

3. Suggestion of possible solutions 

4. Their elaboration and evaluation 

5. Belief, decision, action 

Let us examine these factors in greater detail, to ascertain what sugges¬ 
tions they may afford for our problem of training. 

1. A felt difficulty .—The indispensable precondition of all thinking is 
something to think about, a problem too complex or too novel to yield to 
such simpler and less burdensome methods of attack as instincts, habit, or 
memory. It may be either an intellectual or a practical difficulty, present 
or anticipated. Such a predicament serves as the stimulus for thinking, 
and determines the direction thought shall take. “Use your head! Think 
about it!” is the most futile—yet by no means the most infrequent—advice 
a teacher ever gives a stupid pupil w r ho can see no problem about which to 
think—other than the eminently practical problem of getting the teacher 

1 John Dewey, How We Think , chap. vi. (Boston, 1910.) 


WAYS OF DEALING WITH RISK: TRANSFER 


49 


to lay oil him.” Recognition of this fact has led to the increasing vogue 
of the “project-method” or “problem-method” or “case-method” of 
organizing educational procedure. 

The business man’s problem may perhaps assume the form of an emer¬ 
gency demanding action, but no action suggesting itself; or a suggestion 
of doubtful merit may come to mind; or two or more possible courses of 
action may suggest themselves, necessitating deliberation and choice. If, 
as often happens, the problem makes its first appearance in very definite 
form, the second and perhaps the third of the stages enumerated may be 
omitted—or rather, condensed into the first, in the way previously men¬ 
tioned. The task then becomes one of weighing and evaluating these 
suggestions. But sometimes the situation is so involved in character that 
its key is not apparent, and the second step mentioned, that of defining the 
problem and locating the difficulty, becomes the immediate task. 

2. Defining the problem .—This is essentially a matter of analyzing the 
situation into its factors, significant and non-significant. Thus, a slump in 
sales in a given territory may conceivably be due to any of a considerable 
number of factors, and a large part of the task of relieving this particular 
difficulty consists in analyzing the situation into its factors, geographical, 
financial, personal, social, political, etc., and determining which are signifi¬ 
cant and to what extent. Only then can one look for an adequate solution 
to suggest itself. The problem may, on analysis, define itself as essentially 
a problem of ( a ) putting in more efficient salesmen; ( b ) meeting prices or 
terms of a local competitor; ( c ) improving transportation or delivery condi¬ 
tions; ( d ) counteracting harmful propaganda; (e) making connections with 
new dealers; (/) stimulating present dealers to greater efforts—or something 
else. One or another of these, in turn, may call for still further definition. 

It will be evident that only one who has a thorough familiarity with 
the subject-matter to which the problem relates can tell at a glance which 
factors are significant and which are not. We cannot insist too strongly 
that no efficient thinking about any problem can be done without a knowledge 
of the facts in the case. Contrary to a notion that is still altogether too 
popular, reasoning is no empty, formal, logical gymnastic, in which one can 
exercise himself into expertness without regard to the peculiar nature of the 
materials involved. No matter how good a thinker a man may be in his 
own field, he can never carry over ioo per cent thinking efficiency to a field 
in which he is not at home. True, his previous training in thinking may be 
of assistance to him in acquiring familiarity with a new body of material, 
in mastering the strange viewpoints, terms, principles, and technique; but 
only actual mastery of the raw materials can make possible good judgment 
about any sort of problem. We see daily illustrations of foolish and incom¬ 
petent judgments uttered by men who are experts in their own lines, but 
whose opinions, when they venture into territory filled with unfamiliar 
facts, principles, and technique, are not only valueless but indeed socially 


5o 


RISK AND RISK-BEARING 


injurious, simply because their susceptible readers fail to make this funda¬ 
mental distinction. 

During this analytic stage a sifting process has been going on. A host 
of irrelevant details, offering no promise of help, have quietly dropped out 
of sight. Simultaneously, certain others have proved suggestive, pointing 
out hopeful lines of inquiry, and rising to positions of central importance in 
dominating thought and determining the direction it shall take. So we 
reach the third stage, that of suggestions of solutions. 

3. Suggestion of solutions .—Suggestion or association is a fundamental 
psychological principle, basic in all habit and memory. We recall a thing 
only when an associate, sensory or ideational, is at hand to suggest it; in 
the absence of such stimulus we are helpless. We can, however, actively 
aid the recall process by assembling before us all available stimuli, in the 
hope that one or another will have retained a sufficiently strong connection 
to suggest the thing we are seeking. Now an analysis of any problem does 
just this: it brings out and impresses on us certain vitally significant facts 
to which we must look to suggest the way out. These serve to set limits 
to the range of “trials and accidental successes” which play so central a 
role in all problem-solving, whether on motor or ideational levels. If we 
have had previous experiences of the particular type to which our problem 
belongs, such associations will naturally have been established, and sugges¬ 
tion will occur actively. 

Here again is evident the vital necessity of a background of knowledge. 
The business man confronted with a problem of a sort entirely foreign to 
his previous experience feels helpless, because absence of associations gives 
him no clue to the way out. Mistakes of judgment are often directly trace¬ 
able to inadequate knowledge and consequent insufficiency of possible 
suggestions, or to inadequate appreciation of the implications of such 
suggestions as do arise. Probably the most common of all logical fallacies 
is overhasty generalization. A single experience, or a striking occurrence, 
is elevated to the dignity of a general truth and applied indiscriminately to 
all sorts of situations, usually with disastrous results. Business men fail, 
more often from incapacity than for any other reason, and incapacity usually 
means ignorance of things one should know about his own business. On 
the other hand, the leader in the financial and industrial world is not infre¬ 
quently a man of remarkably wide information concerning matters psy¬ 
chological, social, political, geographical, historical, and scientific, which to 
his smaller-minded contemporary seem irrelevant and useless. Neverthe¬ 
less, it is just this rich background that suggests to him the probable effects 
upon general business conditions, and hence upon his own affairs, of influ¬ 
ences apparently remote, and yet real, and thus enables him to prepare for 
future contingencies. Those business men who were hit hardest by the 
post-war depression were, in many cases, those who a few years before knew 
only that the way to greater profits was by buying larger stocks on rising 


WAYS OF DEALING WITH RISK: TRANSFER 


51 


markets, but who did not have that larger knowledge of social and economic 
conditions, past and present, which would have warned them of what must 
inevitably follow. 

Let us recall once more that familiarity and practice make for short 
cuts in this associative process, so that as soon as the problem appears, a 
course of action may suggest itself, even though we do not stop to trace 
the path—or perhaps not even be able to do so if we try—which logically 
leads from the one to the other. The series, “A-B-C-D-E,” built up in 
the past, becomes condensed and short-circuited into the direct association, 
“A-E.” This facility in practical judgment is a priceless asset to the 
executive; such judgments constitute a large part of his everyday thinking. 
But behind his quick and certain judgments, which evoke our admiration, 
we may be sure there lies a history of years of faithful, often tedious, accumu¬ 
lation of intellectual capital and rigid discipline in its use. 

Akin to these practical judgments are those uncritical and unanalyzed 
impulses which we call “hunches” or “intuitions,” and which play a 
disproportionately large part in some people’s decisions. Such judgments 
differ from the kind we have been describing not in their essential elements, 
but simply in the greater obscurity of the specific factors, both in the objec¬ 
tive situation and in the individual’s personal history, which stimulate 
the suggestions and determine the decision, and hence in the relatively 
greater part played by feeling and impulse. Sometimes, it is true, a man’s 
feelings and impulses have been unwittingly trained by long experience, so 
that his “hunches” are better than mere lucky guesses, even though he 
be incapable of making the self-analysis that would bring their historical 
origins to light. But let us not overlook the fact of our proneness to remem¬ 
ber and overstress our fortunate guesses, and to forget our mistakes, and 
so to develop a superstitious reverence for our “intuitions.” In spite of 
their occasional inevitability, it is unsafe to form the habit of substituting 
such impulses for critical judgments, if we can possibly find any basis for 
critical judgments. 

If the operations thus far described—discriminative analysis of the 
problem, and associative suggestion of solutions—have sufficed to over¬ 
come all inhibitions to action and induce that attitude of readiness to act 
which we call belief, decision and action follow automatically. If not, we 
proceed to seek for further evidence of the relative practicability of our 
hypotheses. This constitutes the fourth stage of our schema—the elabora¬ 
tion and evaluation of the suggestions; and this is what distinguishes critical 
reasoning and sound judgment from uncritical opinion, impulse, or fancy. 

4. Elaboration and evaluation of solutions .—By elaboration is meant the 
consideration of such consequences, positive or negative, agreeable or 
disagreeable, as may be expected to follow from this or that course of action. 
This again involves associative suggestion, and efficiency in doing it 
depends directly on whether or not the individual has sufficient acquaintance 


52 


RISK AND RISK-BEARING 


with the facts in question to know what their consequences may reasonably 
be expected to be. Some of this knowledge comes from study or reading; 
some of it comes from first-hand or second-hand experiences with people 
and things. To a large extent, the implications which one who makes 
business judgments must consider are social, involving an understanding 
of how people act, individually or collectively. When we consider extending 
credit to a man we want to know about his past career, his present habits, 
his future purposes, in order to be able to predict the probable outcome of 
our venture. When we consider investing, or enlarging our business, we 
are anxious to know how “conditions” will be in a year or two years or five 
years, which means simply that we want to know what the mass of buyers, 
sellers, investors, and workers are likely to be doing, testing-out of the hypo¬ 
thetical conclusion is called for. We may test hypotheses in various ways. 
We may try out our plan experimentally on a limited scale to ascertain 
whether it will work as we expect. Or we may try it out on the “reflective 
level” by testing it against other accepted general principles, or with the 
testimony of competent authorities, books or persons, on similar or related 
problems; or we may submit our data, methods, and conclusions to com¬ 
petent critics to discover possible omissions or errors. One of the marks 
of the wise business man is his judicious choice of counselors. 

5. Action .—After the problem has been defined, suggestions for its 
solution reached, elaborated, and evaluated, one of two things happens. 
If the process has been unsuccessful, it is repeated and new analyses and 
solutions attempted. If it has been successful and the attitude of belief 
has been induced, the final stage, that of action , takes place. The con- 
summatory act need not, of course, follow immediately. The direct out¬ 
come of a reasoned business decision may be a more or less explicitly 
formulated program for future action. If the decision covers a whole class 
of anticipated situations, we call it the formulation of a policy. The realiza¬ 
tion of these conditions then automatically brings the act which 
consummates the process; the crucial point was reached and passed when 
the act of decision was accomplished. What has been said about the ever- 
imminent dangers of hasty generalization, of undue susceptibility to emo¬ 
tional bias, of the urge of impulse and prejudice, of post-rationalization of 
motives, and like enemies of logical thinking, means simply that a critical 
attitude is no less essential for sound business judgment than for sound 
scientific judgment. 

To develop good business judgment, then, is not a hopeless undertaking. 
Indeed, assuming reasonably good quality of brain stuff, good judgment is 
acquired by a student in no other way than through training— that is, through 
practice in discovering problems to think about, in getting, reflecting on, 
and working over the indispensable capital of knowledge, in analyzing 
problems and sifting facts, in organizing data and keeping them organized 
to facilitate suggestions, in guarding against too hasty generalizations or 


WAYS OF DEALING WITH RISK: TRANSFER 


53 


emotional bias, in maintaining an attitude of suspended judgment, in criti¬ 
cally verifying hypothetical conclusions. And to train him in doing these 
things is a primary function of the school of business. 1 

NOTE I 

UNMEASURABLE RISK AND THE NATURE OF JUDGMENT 

The contrary view to that expressed in the text, page 46, is held by 
Professor Knight, and is made central in much of his treatment of the theory 
of risk. In his view, cases where there is no statistical or mathematical 
basis for determining the degree of probability are the only cases of true 
uncertainty, and the decisions in which they figure are not based on any¬ 
thing comparable to the statistical method at all. The only way of dealing 
with these risks is to assume them, acting on the hypothesis which is 
estimated to be most plausible. The making of such an estimate he seems 
to regard as a purely reflex act of consciousness, concerning which nothing 
really significant can be said: 

The mental operations by which ordinary practical decisions are made are 
very obscure, and it is a matter for surprise that neither logicians nor psychologists 
have shown much interest in them. Perhaps (the writer is inclined to this view) 
it is because there is really very little to say about the subject. Prophecy seems to 
be a good deal like memory itself, on which it is based. When we wish to think 
of some man’s name, or recall a quotation which has slipped our memory, we go 
to work to do it, and the desired idea comes to mind, often when we are thinking 
about something else, or else it does not come, but in either case there is very little 
that we can tell about the operation, very little “ technique.” So when we try 
to decide what to expect in a certain situation, and how to behave ourselves accord¬ 
ingly, we are likely to do a lot of irrelevant mental rambling and the first thing we 
know we find that we have made up our minds, that our course of action is settled. 
There seems very little meaning in what has gone on in our minds, and certainly little 
kinship with the formal processes of logic which the scientist uses in an investiga¬ 
tion. We contrast the two processes by recognizing that the former is not reasoned 
knowledge, but “judgment,” “common-sense,” or “intuition.” There is doubtless 
some analysis of a crude type involved, but in the main it seems that we “infer” 
largely from our experience of the past as a whole, somewhat in the same way 
that we deal with intrinsically simple (unanalyzable) problems like estimating 
distances, weights, or other physical magnitudes when measuring instruments are 
not at hand. 

We know that estimates or judgments are “liable” to err. Sometimes a 
rough determination of the magnitude of this “liability” is possible, but more 
generally it is not. In general, any determination of the value of an estimate must 

1 Adapted by permission from Forrest A. Kingsbury, “Business Judgment and 
the Business Curriculum,” Journal of Political Economy (June, 1922), pp. 375-88. 
It may be noted that the term “judgment” is used in this selection in a slightly 
broader sense than that in which the author has used it above, to include cases 
where absolute certainty is finally attainable. 


54 


RISK AND RISK-BEARING 


be secured by the tabulation of instances of accuracy and inaccuracy of similar 
estimates, thus reducing it to a probability of the statistical type. 

The theoretical difference between the probability connected with a mere 
estimate and that involved in statistical calculations such as those used in life 
insurance, is clearly discernible. Take as an illustration any typical business 
decision. A manufacturer is considering the advisability of making a large com¬ 
mitment in increasing the capacity of his works. He “figures” more or less on the 
proposition, taking account as well as possible of the various factors more or less 
susceptible of measurement, but the final result is an “estimate” of the probable 
outcome of any proposed course of action. What is the “probability” of error 
(strictly, of any assigned degree of error) in the judgment ? It is manifestly mean¬ 
ingless to speak of either calculating such a probability a priori or of determining 
it empirically by studying a large number of instances. 

Yet it is true, and the fact can hardly be over-emphasized, that a judgment of 
probability is actually made in such cases. The business man himself not merely 
forms the best estimate he can of the outcome of his actions, but he is likely also 
to estimate the probability that his estimate is correct. The degree of “certainty” 
or of confidence felt in the conclusion after it is reached cannot be ignored, for it is 
of the greatest practical significance. The action which follows upon an opinion 
depends as much upon the amount of confidence in that opinion as it does upon the 
favorableness of the opinion itself. The ultimate logic, or psychology, of these 
deliberations is obscure. We must simply fall back upon a “capacity” in the 
intelligent animal to form a more or less correct judgment about things, an intuitive 
sense of values. W T e are so built that what seems to us reasonable is likely to be 
confirmed by experience, or we could not live in the world at all. 1 

The issue here raised is fundamental. The view of the nature of busi¬ 
ness judgment just quoted is in harmony with Professor Knight’s view of 
the nature of these cases of unmeasurable uncertainty. If the uncertainty 
we cannot measure is of a totally different character from that which we 
can reduce to a mathematical ratio by statistical surveys, if there is indeed 
no objective basis for an opinion of probability, it must be conceded that 
the only way we can deal with it is by a pure creative act of intelligence, 
“an intuitive sense of values” (or, more accurately, a recognition of truths 
yet to be born). 

In the view of the present writer, however, such a hypothesis, while 
hardly capable of disproof, ought not to be accepted until other alterna¬ 
tives have been found untenable. Reliance on an intuitive sense of values, 
as a means of prediction of occurrences outside our own spiritual experience, 
is practically indistinguishable from sheer blind guesswork, dependence on 
which is indeed psychologically thinkable but, we hope, not our final 
and only resource in dealing with problems of uncertainty. 

Rather it appears probable that the cases of “statistical probability” 
and the cases of “true uncertainty” are essentially alike, differing only in 
the amount of information we happen to have at hand to deal with them, 

1 Knight, op. cii., pp. 211, 225-57. 


WAYS OF DEALING WITH RISK: TRANSFER 


55 


the length of time necessary to accumulate a line of cases big enough to 
establish a statistical frequency, or the fineness of the classification we are 
using. All applications of the law of averages rest on a grouping of things, 
unlike in many respects, into classes, on the basis of certain similarities; 
if cases nearly alike are infrequent, we must do our grouping on the basis 
of less homogenous classes. If the classification is crude, or if the cases 
are not numerous, the statistical method loses its accuracy. But these 
cases certainly shade off into Professor Knight’s “true uncertainties” by 
imperceptible degrees, the margin of error getting larger as the evidence 
grows more scanty. 

There are, indeed questions concerning which no evidence whatever 
exists, but it does not appear probable that the human mind is equipped 
in any way to grapple with them. And if any basis for judgment does 
exist there seems to be no way to exercise it except to throw our cases into 
crudely formulated “like cases,” and form an opinion on the basis of the 
preponderance of the evidence. That the process is largely automatic 
and unconscious is of course obvious. 

The view that the so-called “true uncertainties” are cases which would 
show statistical regularity, if a sufficient number of like cases were available 
for comparison, is confirmed by the fact noted by Professor Knight 1 that 
the totally unpredictable cases do show some tendency toward regularity 
when grouped with other similarly unpredictable data. 

QUESTIONS 

1. The ultimate effect of improvements in business methods is usually to 
lower prices to consumers, yet society depends on the self-interest of 
business men, through profits, to secure the adoption of improvements. 
Is this rational? 

2. Profit is sometimes stated to be a compensation for the “irksomeness” of 
riskbearing. Discuss. 

3. Can you cite cases where profit is collected without either monopoly 
conditions or significant risk, a) temporarily? b ) permanently? 

4. Outline ( a ) the qualities which enable one best to become a business 
manager; ( b ) those which fit one best to succeed as a business manager. 

5. What do you mean by “accepting responsibility?” Would the expres¬ 
sion mean anything in the absence of uncertainty concerning the out¬ 
come of one’s decision ? 


1 Op. cit., p. 239. 


CHAPTER IV 


WAYS OF DEALING WITH RISK: TRANSFER 
TO SPECIALISTS —Continued 

Besides the general system of organization which results in a 
transfer of risk from capitalists and laborers to business enterprisers, 
specialization has produced numerous types of organization to which 
it is possible to transfer certain of the risks of business. Indeed, 
specializing in risk-bearing is one of the most striking phases of our 
modern differentiation of functions and functionaries. The most con¬ 
spicuous illustration is of course the insurance company, but there are 
a great many others. Corporate suretyship, guaranty of real-estate 
titles, guaranteed collection services, and the hedging facilities offered 
by produce exchanges are illustrations. 

The assumption of risks for others looks at first like an extremely 
hazardous way of building an income. It is not necessarily, however, 
more risky than other forms of business enterprise, for the risk-bearer 
is usually better able to carry the risk than is the one from whom it 
is removed. This superiority may be due to superior knowledge of 
the situation, as when a title-guaranty company investigates a real- 
estate title, satisfies itself that there is no real risk, and then guarantees 
the validity of the title. The owner of the property gets rid of the 
risk by transfer, the guaranty company assumes it, but reduces it to 
a minimum by research. 

In a second class of cases the risk is transferred to a specialist 
who is able to reduce it by prevention. This is illustrated when an 
investment bank guarantees the sale of a bond issue, knowing that 
its own indorsement will assure the success of the flotation, or 
when a steam-boiler insurance company issues a policy to protect the 
owner of a plant and then furnishes an elaborate and efficient inspec¬ 
tion service to reduce the hazard of loss. In a third class of cases the 
reduction of risk arises from the fact that the specialist who assumes 
the specific risk combines it with a great number of others and so 
reduces the amount of uncertainty, and hence the amount of risk 
through operation of the law of large numbers. This is the basic 
principle of most forms of insurance. 


56 


WAYS OF DEALING WITH RISK: SPECIALISTS 


57 


For all these forms of enterprise the chief hazard is not the hazard 
insured against, but the risk of failing to get sufficient business to 
furnish a working basis for the law of large numbers, or to repay the 
costs of organization. 

It should be noted, however, that in all these cases the substitu¬ 
tion of certainty for uncertainty effects a saving of indirect losses 
resulting from the event insured against, even though the direct losses 
are not reduced in number. Fire insurance affords a convenient 
illustration. Suppose that in the space of five years on an average 
i per cent of buildings of a certain type are burned and that the cost 
of selling insurance, keeping track of the business, investigating 
claims, etc., together with the profits of the insurance company, 
brings the cost of insurance on such buildings up to 2 per cent. Sup¬ 
pose A insures and B refuses to do so. It is evident that in the long 
run A will pay out twice as much for insurance premiums as B will 
lose by fires. But if B has only one or two buildings, the “long run” 
necessary to make him fairly sure of this saving will be a great deal 
longer than his lifetime. Instead of saving the difference between the 
amount of the premiums and the average or normal loss, he gambles 
for the saving of a larger amount. If he is lucky enough to have 
no serious fires, he saves the whole premium. If his building is 
destroyed, he probably will never live long enough to save the amount 
lost out of his insurance premiums. Moreover, if he has his whole 
capital sunk in one building he has no chance to save any of the loss 
in this way until he has accumulated enough to put up another 
building. If the building is used for business purposes, moreover, 
its destruction is likely to mean not only the loss of the value of the 
building, but also the loss of business, good will of customers, etc. 
Part of this loss is unavoidable, but an insurance policy which enables 
one to rebuild quickly or to pay off debts which have been secured by 
the building may enable him to save a large part of this indirect loss. 

One of the most important risks with which we have to deal is that 
which arises from the uncertainty of the length of human life. This 
takes two forms—the risk that one may live so long as to use up the 
funds which he has provided to support himself in old age and the 
risk that he may die before the end of his normal working life. Each 
contingency needs to be provided against. 

The first is taken care of in large part by the method of reserves, 
the individual setting aside a part of his earnings as a provision for 
old age, a larger part in many cases than would be necessary if the 


53 


RISK AND RISK-BEARING 


length of life were known. The life annuity is a special device for 
taking care of this risk. This is a contract whereby an insurance 
company or other corporation agrees for a fixed sum to pay a given 
individual a stipulated income so long as he lives. For one who will 
live only an average period, the contract is not ordinarily an attractive 
investment, but it relieves him of the risk of using up all his savings 
and coming to want because of an unexpectedly long life. The pure 
endowment is another contract which insures against a risk arising 
from the length of life. It is similar to an annuity except that the 
person taking out the contract pays his money in annual instalments 
for a term of years, and at the end of that time receives a lump sum. 
If he dies within the stipulated time, nothing is paid by the company. 
Such contracts have been used in Europe by parents to provide for 
the expense of higher education of their children, or to provide dowries 
for daughters. Endowment-life policies combine pure insurance and 
pure endowment in one contract. 

The second type of risk connected with human life is the risk of 
death before one’s normal working life is completed, with consequent 
loss of earnings. The way which this risk is shifted to insurance 
companies will serve as an illustration of what we mean by the elimina¬ 
tion of risk through specialization and combination. For the indi¬ 
vidual, there is nothing more uncertain than the duration of his life. 
For the insurance company, on the other hand, the insurance contract 
involves very little risk. Which of the insured will die no man knows; 
how many will die, u the number of insured is large, can be predicted 
with great accuracy. Hence the company can profitably sell the 
insurance at a price at which it is a good bargain for the insured. 

Outside the fields of fire and life insurance, the most important 
branch of the insurance business is marine insurance. Newer types 
which are gaining rapidly in popularity are burglary, plate glass, 
automobile, and credit insurance. In all these cases, the principle is 
the same. If a business has a large enough number of risks and if the 
risks are independent of one another, it is likely to be cheaper not to 
insure, for unless the insurance company receives a great deal more in 
premiums than it pays out for losses it cannot continue to do business. 
A railroad company need not insure its station buildings, and a large 
business owning many buildings with plate-glass windows need not 
insure them against breakage. The amount paid out in premiums 
will be greater than the amount needed to replace the damage. In 


WAYS OF DEALING WITH RISK: SPECIALISTS 


59 


the same way, a large number of small risks of different kinds may be 
allowed to offset one another. Wherever such a distribution of risk 
cannot be secured, however, assuming that the expense loading and 
profits of insurance companies are not excessive, all insurable risks 
should be insured against, for the insurance company, having a wider 
distribution of risk, can definitely count on a smaller variation in the 
number of losses than can any one individual, and hence can get along 
with smaller reserves withdrawn from active business use to guard 
against the impairment of working capital. 

The field covered by insurance companies, however, is much 
narrower than the field of risk involved in carrying on business. 
For a risk to be well adapted to insurance and elimination by combina¬ 
tion, two conditions are necessary. There must be available for 
insurance coverage a large number of independent risks, and the 
probability of the occurrence of the event insured against must be 
known with fair accuracy. If the first condition is absent the insur¬ 
ance is speculative; if the second is absent it is impossible to determine 
a fair rate, as the combination of risks does not afford knowledge 
as to the total losses to be anticipated. Insurance under either of these 
conditions involves simply a transfer of risk from one individual to 
another, without reduction, and is speculative in character. To meet 
the need for insurance or for protection against various types of loss 
where no statistics are available from which to calculate the expected 
loss, or where no proper distribution of risk can be obtained, the Lloyd’s 
type of speculative insurance has been developed. In this type of 
contract, a large group of private insurers enter into a contract by 
which they agree to recompense the insured for his loss dividing the 
cost between themselves. For example, people in Washington owning 
property along the line of march of the inaugural procession sometimes 
insure themselves against loss from bad weather on the fourth of March 
through the London Lloyd’s. The insurers in this case may secure a 
distribution of risk, in spite of the fact that if they have a loss on one 
policy they will have a loss on every policy of this type. This is done 
by diversifying the contracts. If the individual insurer writes many 
policies and none are large, he secures a combination of risks which 
protects him against excessive loss. But there is a large speculative 
element involved in the fixing of the premium rates. Protection 
against drought is of this character. So long as such policies are 
written to cover a bona fide risk and not for speculation, they are as 


6o 


RISK AND RISK-BEARING 


useful as any other type of insurance, but the device obviously lends 
itself admirably to gambling and is often used for that purpose . 1 
In the earlier days of life insurance, it was permissible for anyone to 
take out insurance on the life of anyone else, and policies practically 
of the Lloyd’s type, on the lives of public men were often taken out 
purely for gambling purposes. 

Very similar to the speculative type of insurance is the practice 
of hedging. This is the practice of making two contracts at about 
the same time of an opposite, though corresponding, nature—the one 
in the trade market and the other in the speculative market . 2 The 
same possibility of using a contract either for the purpose of hedging 
a legitimate risk or for the purpose of creating a gambling risk which 
we say in the Lloyd’s contracts arises in connection with these “ future 
contracts” on the produce exchanges. When a grain merchant sells 
a future contract to hedge against a fall in prices while he is marketing 
his purchases of cash grain, or a flour-miller buys a future contract 
to protect himself against loss while he is manufacturing flour which 
he has agreed to deliver, they are securing protection against a definite 
risk in much the same way that one secures protection against unknown 
hazard through Lloyd’s policy, but in both cases the only way that the 
insuring or hedging individual gets rid of his risk is by transferring 
it to someone else who assumes it as a speculation. The whole 
machinery of the produce exchange finds its justification in the facilities 
which it affords for carrying on certain types of business with a mini¬ 
mum risk and consequently at a minimum cost. There is no question 
that it is sound business policy to make use of the hedging market 
wherever a hedging contract can be secured on reasonable terms, but 
the existence of a hedging market presupposes the existence of a 
group of speculators who are taking the risk off the business man’s 
shoulders, and there has as yet been found no way to keep these 
contracts from being bought and sold in a purely gambling spirit. 

Another way of transferring risk is what is known as “ contracting 
out,” a method similar to hedging, but not involving the use of a 
speculative futures market. Contracting out may be explained 
briefly as follows: 

The work of the organized exchanges has certain sensational elements, 
and volumes have been written upon these exchanges where sentences have 

1 For fuller discussion cf. chap. xiv. 

2 S. S. Huebner, “The Functions of Produce Exchanges,” Annals of the Ameri¬ 
can Academy of Political and Social Science, XXXVIII (1911), 392. For fuller 
discussion, cf. chap. xii. 


WAYS OF DEALING WITH RISK: SPECIALISTS 


61 


not been written upon the vastly greater volume of speculative contracts 
entered into outside the limits of the organized exchange. These speculative 
contracts are so well known that a simple illustration will suffice. I decide 
to build a house. A contractor assumes the task. He then proceeds to 
make sub-contracts with the purveyors of lumber, bricks, and other mate¬ 
rials to the effect that these materials shall be delivered to him at a certain 
future time and at a certain price. The main contractor has thus con¬ 
tracted himself out of risk with reference to price changes in these materials. 

Our contractor has thus been relieved of much of his risk. 

The foregoing illustration is typical. A man agrees to do a certain 
thing. He then contracts himself out of certain phases of the risk involved. 
True, the burden is merely transferred to someone else, but presumably 
this someone else is a specialist, and therein is the social defense. 1 

In the building industry and in some lines of manufacturing, it 
is practicable to pass on in this way the risk of price changes in nearly 
all the important cost items except labor; this latter risk the manager 
must ordinarily himself assume if he contracts in advance to sell his 
product at a given price. During the war, however, it was not 
uncommon for building contractors to rid themselves of this risk by 
stipulations that the contract price should be readjusted in case 
changes in wage rates should occur before the completion of the 
job. 

In many lines of commercial and manufacturing enterprise, risks 
can be passed on by coupling advance sales with advance purchases; 
in other lines, the risks must be assumed but can be kept at a minimum 
by keeping inventories and advance orders low. Quick turnovers 
give relatively little chance for profit or loss from price changes. 

It is usually the case, however, that at some point in the chain 
of successive buyers and sellers the possibility of contracting out or 
coupling purchases and sales disappears. Someone must assume 
the risks; the fact that the one who assumes them is a specialist 
means that he has superior facilities for judging the situation, if a 
basis for judgment exists, but it also means, as a rule, that he does not 
secure a good distribution of risks. 

QUESTIONS 

1. Does insurance reduce risks or does it transfer risks from the individual 
to society ? 

2. Should a state carry insurance on its buildings? 

1 Adapted by permission from L. C. Marshall, Industrial Society , pp. 501-2. 


62 


RISK AND RISK-BEARING 


3. B, a dealer, has 500 automobiles in stock. Should he insure them? 

4. Give some examples of cases when it is cheaper to run risks than to 
avoid them. 

5. Should the amount of the insurance carried on buildings depend on 
their cost or on present cost of replacing them ? 

6. C is supported by the income from his wife’s property and does not 
work. Should his life be insured? Should his wife’s life be insured 
in his favor ? 



CHAPTER V 

UNCERTAINTY AND THE BUSINESS CYCLE 

One direct result of the presence of uncertainty in economic 
affairs is of such general interest and is so fundamental to an under¬ 
standing of the working of a competitive business organization as to 
require more careful study than we have found it necessary to give 
to most aspects of the risk problem. This is the tendency of produc¬ 
tion in certain lines to exhibit a fairly regular alternation of excessive 
activity and stagnation. Maladjustment of production and consump¬ 
tion we should expect to find as a result of the presence of uncertainty 
in the calculations of producers, but the presence of a rhythm of over¬ 
production and underproduction as a result of this uncertainty requires 
special explanation. 

In the following pages will be presented, first, a description of the 
phases of the business cycle as they have typically shown themselves 
in recent years, and second, a discussion of the causes of the phenomena 
described, with particular reference to the extent to which the cause 
is found in the existence of business risk. 

The stages of the typical business cycle are generally considered 
to be four: depression, improvement, prosperity, liquidation. 
Although it is sometimes impossible to state accurately the time 
at which one of these stages merges into the following one, the classi¬ 
fication is convenient and we shall utilize it in describing the 
phenomena of the cycle. Let us start our description with a period 
of depression, such as existed in the United States in 1894, in 1908, 
and in 1921. 

Depression is characterized by low production , low prices , and low 
profits .—The most conspicuous fact about the whole industrial and 
commercial organization, as it appears at such a time, is its amazing 
inefficiency. It is like a well-oiled machine stuck on a “dead center.” 
Mills stand idle, mines are closed, freight cars are empty, and fleets 
rot at the wharves. The falling off in the volume of physical produc¬ 
tion runs in some industries to 50 or 60 per cent, while many individual 
firms completely suspend operations. Different lines of business are 
very differently affected, however. At the one extreme, among the 
major industries, stands agriculture, in which the volume of production 

63 


64 


RISK AND RISK-BEARING 


is usually not reduced at all. Individual farm products have their 
own cycle of overproduction and underproduction, but these rarely 
correspond to the cycle of general business. 1 Bakeries, ice plants, 
distributors of fresh milk, and other producers of perishables expe¬ 
rience a very slight falling off in their volume of business. On the other 
hand, dealers in canned foods and preserved meats, flour-millers, and 
most producers of staple non-perishable goods experience a drastic 
reduction in the demand for their products. Bituminous coal pro¬ 
duction is curtailed much more than anthracite. Production of pig 
iron, copper, zinc, and other industrial metals is greatly reduced. The 
building industry is likely to be greatly curtailed in its operations in 
the early stages of a depression, but residence and public construction 
pick up rapidly, encouraged by the lower costs of materials and labor 
which characterize such a period. Trade, as a rule, is reduced less 
than manufacture and retail trade less than wholesale. Prices are 
low; prices of raw materials lower than those of half-finished products, 
and those of finished goods relatively the highest. 

The volume of unemployment reaches its maximum, as a rule, 
about the middle of a depression, though generally the decline in 
wages lags considerably behind the decline in the volume of business 
and does not proceed as far. The efficiency of labor is high for three 
reasons: first, because the cutting down of industrial forces has taken 
the form of a weeding out of the least efficient; second, because the 
fear of unemployment is a great stimulus to the efficiency of those 
who remain upon the pay-roll; and third, because many laborers who 
are on the border line between two grades of skill get into the more 
skilled class in periods of business activity and drop back into the 
less-skilled class when business is dull, thereby increasing the average 
efficiency of both groups. Strikes are not numerous, though some 
of the most destructive have occurred at just such periods. 

The decrease in the volume of trade and manufacture is reflected 
in the reports of business done by the banks. Bank statements indi¬ 
cate a position of great strength, loans and deposits being low and 
reserve ratios high, but the strength is not as great as it appears, for 
the proportion of uncollectible paper held is at a maximum. 

Profits in most lines of business are decreased more than is gross 
income. Commercial failures are numerous, especially in the earlier 
part of the depression. Interest rates are low. 

1 For illustrations see Warren, Farm Management , pp. 83-90, quoted below, 
pp. 76-78. 


UNCERTAINTY AND THE BUSINESS CYCLE 


65 


Recovery may be either gradual or sadden .—The transition from 
depression to prosperity is typically very gradual, at least in the earlier 
stages of improvement, but occasionally it is startlingly sudden. 
When the latter condition prevails, the recovery will invariably be 
found to have been started by some exceptional circumstance, such 
as the combination of good crops in this country with short crops 
abroad which stimulated business in 1879, or the rush of war orders 
which banished depression early in 1915. If no such favorable inci¬ 
dent occurs, the depression itself gradually engenders conditions 
which make for recovery, but the recovery in these cases is slow and 
does not affect the whole business world at the same time. Some 
industries are gaining ground while others are still going backward, 
so that it is impossible to recognize the turning point until it has been 
passed. 

Increase of production usually starts at points where it has been 
curtailed most sharply on account of excessive stocks which have been 
carried over from the preceding period of prosperity. Production 
has been curtailed below even the low rate of consumption which pre¬ 
vails during the depression, and as a result the excess is worked off. 
Then new stocks of goods must be produced to satisfy the demand. 
Changes in fashion and the appearance of new kinds of consumption 
goods also sooner or later stimulate increase of production. Most 
important of all, in several cases, has been the revival of building and 
of railway and public utility construction. Investments of this 
character are made with a view to the distant future, hence the 
immediate prospect of dull business may be offset by the relative 
cheapness of materials and labor, whereas producers of goods for early 
consumption must be governed more by the outlook for markets in 
the near future than by considerations of economy in the costs of 
production. 

Once the increase in business activity gets under way it is likely 
to radiate with increasing rapidity. If building industry expands, 
brick, cement, and lumber interests feel the effects at once; steel, 
copper, and transportation, a little later. Each of these passes its 
growing prosperity to others. Later still, retail buying shows some 
effect of the increased volume of employment. No single enterprise 
is self-sufficient; each is influenced by the fortunes of its customers 
and of those from whom it buys. 

The effects of the increase of production on the labor market and 
the money market are obvious. Unemployment decreases, and wages 


66 


RISK AND RISK-BEARING 


rise, at first more rapidly than the cost of living, then as prosperity 
develops tend to lag behind until the eve of a crisis, when they begin 
again to run ahead. Bank loans increase, but interest rates are slow 
to follow other prices upward. Banking is one of the businesses 
where an increase in customers’ demand, coming in slack times, can 
be taken care of with the least additional expense, hence competition 
prevents any material advance in rates until the revival has run a 
long way. 

An increase in business activity does not necessarily carry with it 
an immediate advance in most prices. The raw material markets 
are very sensitive because they are as a rule “buyers’ markets.” 
There is very little organization in them to restrict production and 
control prices, consequently prices go very low during depression, and 
the resumption of competitive buying quickly puts them up. The 
case of most manufactured goods is different. Their prices have 
usually been maintained during the dull period to some extent by 
curtailment of output, and manufacturers come into the revival period 
with idle plant capacity, which makes it possible for them to handle 
the increased volume of business with less than proportionate increase 
in expenditures. Hence competition is apt to be keen until the 
expansion of business has proceeded to the point where existing plants 
are booked ahead to capacity, and prices show relatively little tend¬ 
ency to advance. The advances in prices of raw materials and wages 
go far to offset the decrease in overhead costs which results from greater 
volume of business, so that the early stages of recovery do not bring 
large profits to manufacturers, except where monopoly conditions are 
present. 

After a time, however, in one industry after another the expansion 
of demand reaches the stage where manufacturers decide that it will 
pay to raise prices even at the risk of losing some orders, and when 
this process starts it is likely to gain momentum. An increase of 
prices at one point means an increase of costs at another, and coming 
in conjunction with an increase in orders and inquiries, it encourages 
price increases where it does not make them imperative. 

At first, higher prices check demand, for buyers, both middlemen 
and consumers, are thinking in terms of a falling or stationary price 
level, and they resent and resist advances. But when increases 
become numerous enough to create an expectation of further 
increases, they begin stimulating, instead of retarding, purchases. 
Present purchases and contracts for future purchases are made in 


UN CERTAINTY AND THE BUSINESS CYCLE 67 

anticipation of further advances, and speculators, middlemen, and 
consumers begin to accumulate larger stocks. 

Prosperity tends to develop into excessive activity , which in turn 
causes a reaction. No sharp line can be drawn between the periods 
known as those of recovery and of prosperity, but it is possible to draw 
a fairly clear distinction between a wholesome type of prosperity and 
the overexpansion which often appears as a result of prosperity and 
brings it to a close. For prosperity never passes into crisis without an 
intermediate period of false good times when the industrial machine, 
though apparently running at high speed, is really failing to maintain 
its efficiency as an organization for the satisfaction of human needs, 
and is sowing seeds of disaster for those who are directing its course. 

If there were some way by which the progress of the “boom” 
could be checked at the point where production reaches the largest 
volume that existing resources make practicable, the real welfare of 
the nation would be greatly enhanced. When all the available labor 
is employed, when our capital resources have been adjusted to keep 
that labor force employed, and when the production of luxuries has 
expanded to provide for a standard of living corresponding to the 
enlarged income of society, the real improvement has reached its 
limit. No further expansion can put more buying power into one 
person’s pocket except by taking out of another’s. 

But unfortunately there is no force operating to check the boom 
at this time, and there are forces operating to drive it further. Of 
these, the most important is the anticipation of a further rise in prices. 
The higher prices go, and the longer the time during which they have 
been advancing, the greater becomes the number of people who feel 
sure that the next change will be another advance, and this conviction 
gives rise to an epoch of speculative buying. The housewife buys a 
dozen cans of food where ordinarily she would buy three, the retailer 
loads his shelves, and the manufacturer lays in an extra stock of raw 
materials. Speculators withdraw stocks of goods from the market. 

The effect of these withdrawals of goods from consumption is to 
create temporarily the same situation which would appear permanently 
if a large part of our current production of wealth were withdrawn 
and sunk in the sea. The consumable product shrinks relatively to 
the amount of social energy expended in a production, and hence 
the cost of living outruns the advance in individual incomes. It 
must do so. Individuals may succeed in obtaining such rapid 
advances of wages or profits as will offset for them the advance in 


68 


RISK AND RISK-BEARING 


living costs, but the group, as a whole, cannot do so if a large part of 
its current product is being withdrawn from use in anticipation of 
an increase in its price. 

At the same time, the current product itself is being reduced by 
the operation of forces inherent in the nature of prosperity. The 
pressure of competition brings with it an accumulation of wastes. 
Equipment is kept in operation which might better, as a long-run 
policy, be sent to the repair-shop or the junk heap. Managers 
harassed by customers demanding prompt deliveries neglect details of 
economy. Imperfect goods are shipped to customers on the theory 
that time is more important than quality, and customers accept 
inferior goods rather than risk getting none at all. The efficiency of 
labor declines, and labor absenteeism increases. Strikes multiply, 
and insubordination manifests itself. At the same time, interest 
rates rise, and if the expansion of business is very marked, transporta¬ 
tion facilities prove inadequate. 

All these difficulties accentuate the difficulty of making individual 
incomes and expenditures balance. The boom is no longer adding to 
the real welfare of the nation. It is subtracting from the total pro¬ 
duced at the same time that it is inducing individuals to store up part 
of the product for future consumption, usually for consumption at a 
time when it will be less acutely needed than it is at the time it goes 
into hiding. 

The transition from prosperity to depression is the shortest stage of 
the cycle , but has attracted more attention than has any other stage, 
on account of the spectacular character which it often displays and 
the disastrous consequences which it entails. According to the 
severity of its symptoms, this stage is variously denominated a period 
of retrogression, of liquidation, of crisis, or of panic. The outstanding 
characteristics of the period are pessimism, conservatism, and caution. 
Instead of reaching out for larger worlds to conquer, the captains of 
industry seek to guard their frontiers. 

In brief, liquidation consists of two processes: first, the liquida¬ 
tion of stocks of goods and securities, by selling them or using them 
up without buying or producing an equal quantity to replace them; 
and second, the liquidation of credit, by collecting notes and accounts 
without extending credits in equal amount to replace them. If the 
process were carried through to completion, all business men at the 
end of the period would have their net working capital in cash, with 
no inventories or accounts; banks would have no loans outstanding; 


UNCERTAINTY AND THE BUSINESS CYCLE 69 

and all stocks and bonds would be in the hands of permanent 
investors. 

Of course, in practice nothing remotely approaching this actually 
happens. Individuals liquidate their holdings of raw materials, 
finished goods, and securities, but only by transferring them to others 
who are under less pressure. The total of bank loans is but slightly 
reduced in the most drastic period of liquidation. What occurs is a 
season of testing by which the stronger firms gain at the expense of the 
weaker. One bank may turn its loans into cash, but only on condi¬ 
tion that other banks stand ready to rediscount them or to loan the 
funds to those who are pressed for payment; one speculator may 
liquidate his holdings of stocks or of goods on condition that others 
can secure the funds to take the load off his shoulders. 

In a period of expansion, such as was described above, the culmina¬ 
tion of prosperity and the beginning of a downward trend may take the 
form of pressure for liquidation in either the commodity, the security, 
or the short-time credit market. In 1907, for instance, it was pressure 
for credit beyond the capacity of banks to supply it which precipitated 
the effort to liquidate by dumping goods on the market and slackening 
production; in 1920 it was the overexpanded stocks of certain com¬ 
modities, notably silk and sugar, which led to the demand for liquida¬ 
tion of loans; in 1903 the center of strain was in the security market. 
In either case, the liquidation movement when once started gains 
momentum of itself. 

In the commodity markets, a relatively small amount of forced 
selling, which may be brought about either by apprehension concern¬ 
ing the market for the goods so sold or on account of tension at some 
other point, exerts a depressing influence on prices and creates an 
apprehension of further selling. Holders who are under no real 
pressure market their goods as soon as they become apprehensive, 
make advance sales to profit by the prospective decline, or curtail 
purchases and use up the stocks they have on hand. This depresses 
prices further, and the fall of prices creates financial embarrassment, 
for goods are a basis of credit, and on a falling market curtailment 
of credit is imperative. The financial embarrassments necessitate 
further distressed selling, and so the downward spiral proceeds. 

To avoid complete demoralization, there must be provided some 
organization to check the violence of liquidation and maintain prices. 
This organization can be most effectively furnished by the banks, 
particularly if, as in this country in 1920 and in England at earlier 


70 


RISK AND RISK-BEARING 


times of crisis, they are well enough organized to resist the temptation 
to try to force liquidation ahead of one another. Credit extensions 
are arranged, and funds are provided to withhold sufficient goods from 
the market to hold prices up as far as seems feasible. If the banks are 
unable to do this, if each strives to protect itself by selling its securities, 
withdrawing its balances from other institutions, and pressing its 
debtors for settlement, crisis passes into panic. But if organization 
is successful in averting the peril, the period is characterized by 
“orderly liquidation.” Prices of raw materials decline; production is 
curtailed in order to apply receipts to payment of pressing obligations 
and also to avoid losses from further price declines; the weakest 
firms pass into bankruptcy, and the next weakest submit to “voluntary 
reorganization” which transfers control to their principal creditors; 
but there is no panic and no sudden collapse of the market for basic 
commodities. 

A similar process of liquidation takes place in the stock market, 
where indeed it usually begins some months earlier than in the com¬ 
modity market. Even more than is the case in the market for raw 
materials and manufactured products, the stock market is financed on 
borrowed funds. Hence it is subject to exactly the same sort of 
pressure which we have described in connection with the commodity 
markets. A decline in prices, however caused, precipitates distressed 
selling by borrowers to protect their loans; this depresses prices 
further; buying is deterred and speculative selling encouraged by the 
decline, and this still further weakens the security pledged for loans. 
The process is more rapid than in other markets, because the propor¬ 
tion of credit is higher and because lenders on stock-market collateral 
do not feel, as a rule, the same obligation to try to protect their 
debtors as do trade creditors and banks loaning to business men on 
the security of inventories and accounts. Here also, as in the com¬ 
modity market, the situation has been saved again and again by the 
intervention of the stronger banks. By buying in large blocks, by 
extending credit to finance buying by others, and by mutual agreement 
to refrain from forcing liquidation by holders of large blocks of stock, 
panic is prevented. 

Such are the major features of the liquidation process; other 
features of the period of retrogression need scant notice only. Rail¬ 
road gross earnings remain large at first, because commitments already 
entered into are carried out, and because the liquidation process itself 
gives rise to a considerable volume of trade. Later they decline 


UNCERTAINTY AND THE BUSINESS CYCLE 


71 


violently and persistently. Total bank transactions decrease; bus¬ 
iness failures increase to from three to six times their former number, 
and dividend payments are curtailed in many instances. Strikes 
continue numerous; wages decline slowly; unemployment increases; 
and the cost of living declines slightly. 

The liquidation period in the nature of the case cannot continue 
long. When it has run its course, however, production does not at 
once resume its previous trend. Partly on account of the existence 
of excess stocks accumulated during the period of rising prices; partly 
on account of the loss of general confidence in the solvency of debtors; 
partly on account of the fear of further declines in prices; partly 
because of a curtailment of consumer demand on account of unemploy¬ 
ment and business losses, a period of dulness is nearly sure to follow. 
This is the stage with which our description began, and with this stage 
it may close. We must now turn our attention to the underlying 
causes of the phenomenon, and particularly to the way in which it 
illustrates the disturbing influence of uncertainty in a society organized 
on the assumption that individual business managers may be expected 
to find and follow the lines of policy which in the long run are most 
profitable to themselves and to the society of which they are a part. 

It is not our purpose to review the numerous theories which have 
been advanced to account for the rhythm of business, theories ranging 
from the dominance of the profit incentive to the form of the banking 
system, from the fluctuation of the rainfall to the exploitation of labor. 1 
Superficially there appears to be a wide disagreement among students 
of economic theory as to the basic causes of the phenomena of the 
cycle, but most of the differences resolve themselves into differences 
of emphasis upon factors which are in no way incompatible with one 
another. Fundamentally, all the theories which seem worthy of 
extended consideration are variations of two points of view. 2 One 
group emphasizes the tendency for the supply of certain types of 
goods to get out of adjustment with the demand for them. The 
realization of an undersupply, for instance, causes a burst of produc¬ 
tion which continues till an excess of supply becomes evident, and 
this situation in turn causes a slackening of activity which continues 

1 Leading theories are summarized in Mitchell, Business Cycles , pp. 3-19, and 
in Hansen, Cycles of Prosperity and Depression in the United States , Great Britain 
and Germany , pp. 81-96. 

2 In this classification the author has followed in part the analysis in Hansen, 
op. cit. 


72 


RISK AND RISK-BEARING 


till the surplus is changed into a deficit. The other group finds the 
basic cause of the cycle in the financial structure of society, including 
under that term: money, credit, prices, and the profit motive. 1 

In the judgment of the writer, the ultimate causes of the cyclical 
movement of business are found in the factors discussed by the writers 
of the first group. The arguments they have presented however have 
not been thoroughly convincing because each writer has discussed the 
operation of the same tendency in the case of a different group of 
phenomena, leaving the impression that in the behavior of that partic¬ 
ular group is to be found the entire explanation of the cycle instead 
of merely an illustration of the way in which a general tendency works 
in a wider field. 

The common element which runs through all the theories of this 
group is the emphasis on the element of uncertainty , chiefly uncertainty 
on the part of producers and middlemen concerning the conditions 
that will prevail in the market when they are ready to dispose of their 
goods. 

This uncertainty characterizes all modern industry, in contrast 
to earlier forms of economic organization, for two principal reasons, 
namely, the length of time involved in the capitalistic process, and the 
durability of most finished goods, which permits alternate accumula¬ 
tion and liquidation of stocks and thereby increases the difficulty of 
predicting the demand at any given time. It was noted in chapter i 
that the uncertainty arising from the length of time involved in pro¬ 
duction and from the dependence of producers on markets causes 
irregularity and consequent risk; the way in which it results in a 
rhythm may be explained as follows: 

In any specialized economic organization, there must be some way 
of directing the specialists in order that each commodity and each 
service may be produced in the proper proportion to the others, 
proper, that is, in the sense that social energy is devoted to the pro¬ 
duction of any commodity only up to the point where additional 
units of it are less useful (by some scheme of measurement), at least 
are less desired by those whose desires are most effective, than addi¬ 
tional units of some other product to which the same productive 
energy might be applied instead. In our own organization, the 
principal devices for securing a balanced output are prices and advance 

1 Typical of the first group are the theories of Hull, Robertson, J. M. Clark 
Warren, and England. The second point of view is represented by Mitchell, 
Veblen, Fisher, and Hansen. 


UNCERTAINTY AND THE BUSINESS CYCLE 


73 


orders. A falling off of orders or a lowering of market quotations 
gives warning to the manager that the rate of production should be 
slackened, and vice versa, an increase of orders or a rise in prices is a 
call from society for an increase of output. The price index is avail¬ 
able to producers in nearly all lines, while advance orders are avail¬ 
able to relatively few. 

While this system works fairly well in most respects it has one 
serious defect. Prices and orders give information concerning the 
prospective state of demand compared with the known facts of present 
and future supply, but they give no clue to the changes in supply 
which they are themselves likely to cause. What a business man 
needs to know in order to plan production scientifically is not merely 
how many units of his product would be bought at a given price, but 
also how many other producers are reaching the same conclusion that 
he is reaching, from the same facts, and are making plans similar 
to his own. If the element of time in production could be eliminated, 
the price system would effect a smooth adjustment of supply to human 
need, so far as need can be expressed through offers of purchasing 
power, but time brings an ineradicable element of risk. For each 
producer needs to know precisely what it is impossible for all to know, 
namely, how many other producers are about to take advantage of 
the same demand that he individually is trying to take advantage of. 
If A’s plans depend on B’s plans and B’s plans depend on A’s plans, 
there is no escape from uncertainty except through an agreement of 
the rivals, or through the intervention of an outside control—in either 
case, monopoly. 

One result of this situation is a tendency to alternations of over- 
and underproduction. Let us assume that at a given time there is 
evidence of demand in a given line sufficient to justify an increase in 
the rate of production. The first managers who adapt their plans to 
this situation are probably rewarded by increased profits. Under 
competition, however, the tendency is for an increasing number of 
persons to try to take advantage of the situation, each more or less 
in ignorance of the other’s plans, and no force intervenes to check the 
continued increase of production till it reflects itself in declining orders 
and falling prices. By that time, however, investments have been 
made, contracts let, and operations started which will result in fur¬ 
ther augmentation of the supply. Time is required to check this 
increase in the volume of production, and during this time production 
outruns consumption unless consumption is stimulated by unprofitably 


74 


RISK AND RISK-BEARING 


low prices. Moreover, just as was the case on the upswing, the indica¬ 
tions that production is being overdone result in curtailment of opera¬ 
tions by independent producers in ignorance of each other’s intentions, 
and this tendency continues till output is decreased to a rate below 
that which is economically justified. 

A second cause of the cycle, very similar to the first but quite 
independent of it, is the effect of uncertainty on the decisions of 
speculative buyers with regard to the accumulation and decrease of 
stocks. Throughout the industrial order, a large part of the transfer¬ 
able wealth, including raw materials, half-finished products, and goods 
ready for consumption, is in the hands of individuals who can, to a 
greater or less extent, adjust the size of their holdings to changing 
conditions, and who do as a matter of fact adjust them chiefly in 
accordance with their judgment of the probable course of prices. The 
most conspicuous illustration is the case of the simon-pure speculator, 
who stands ready to buy anything at any price if he thinks it will go 
higher, and to throw everything on the market if he believes the price 
is destined to reach lower levels. But it is not merely the speculator 
who behaves in this fashion. The manufacturer adjusts his purchases 
of raw materials and the extent to which he produces for stock to his 
judgment of the trend of prices; the middleman enlarges his holdings 
when he believes the next price change will be upward, and even the 
housewife buys fifty pounds of sugar instead of ten, if she believes 
that the price is a bargain, a bargain, that is, compared with the 
price that is likely to be charged her for the next order. 

This would be of no consequence, so far as the cyclical tendency 
is concerned, if all these judgments of the trend of price were formed 
independently, for some would overbuy when others were underbuying. 
The net result would be a fairly steady rate of buying if the number 
of buyers was large, or an unpredictable irregularity if the number was 
small. But the judgments are not formed independently. They are 
all formed, in large part, on the basis of the same evidence, and of that 
evidence the most influential part is the trend of prices in the recent 
past. Whatever prices have been doing is accepted by a great many 
as the most likely thing for them to continue to do, so that the higher 
they go the more the tendency to speculative buying, and the lower 
they go the more the tendency to use up stocks and buy from hand 
to mouth . 1 

1 Cf. Selden, “Trade Cycles and the Instinct of Anticipation,” Quarterly 
Journal of Economics, XVI, 293-310. 


UNCERTAINTY AND THE BUSINESS CYCLE 


75 


The effect of this tendency to mass movements of buying and 
selling is greatly to accentuate the effect of the producers’ uncertainty 
concerning one another’s plans, to which reference was made in an 
earlier section of this chapter. For an increase in middlemen’s stocks 
gives the producers twice a false index of the amount of production 
which is economically justifiable. When the increase in buying takes 
place it swells the volume of orders and creates a false appearance of 
expansion in the market, and whenever the excess stock is utilized it 
again gives a false indication, this time of contraction in the market. 

The two tendencies, it will be noted, are of fundamentally similar 
character. Producers cannot know the future conditions of supply 
accurately if they operate in ignorance of each other’s actions; hence 
the tendency is for all to act on much the same information and for 
their action to overshoot its intended effect alternately in opposite 
directions. Middlemen, speculators, consumers, likewise operate to 
a large extent in ignorance of one another’s intentions and are likewise 
apt to act simultaneously on the same information, giving rise to 
alternations of abnormally large and abnormally small demand and 
increasing the extent of the uncertainty in the minds of producers. 

In the following selections, two writers give illustrations of the 
working of the tendency to rhythm in widely different fields of 
production. 

THE CYCLE IN PRODUCTION OF BASIC CAPITAL GOODS 

Let us suppose that for any reason the exchange value of the products 
of any trade has risen. There will then be an inducement to increased 
investment in that trade. But the new instruments ordered will not be 
immediately ready for use: meanwhile the high level of price will continue, 
and since each producer (in a competitive regime) is ignorant of the prepara¬ 
tions which are being made by his rivals to meet the high level of prices, 
the total amount of new instruments prepared will be so great that the 

price of the product eventually falls below its old level.The first 

drop in prices will occur as soon as the first batch of new instruments is 
brought into use: the longer therefore this period of gestation, the longer 
will the period of high prices continue, the greater will be the over¬ 
investment, and the more severe the subsequent depression. 

For instance, the price of coal tends to reach both its maxima and 
minima later than that of pig-iron. While there are other causes for this, 
part of the explanation seems to lie in the longer period of gestation necessary 
in the coal trade. According to Mr. Hull it takes “practically a year” in 
America to build a new blast furnace. From an English ironmaster I 
gather the impression that in this country some fifteen months would be 



76 


RISK AND RISK-BEARING 


required. But a coal mine which is begun to be sunk now will not be in 
working order for several years. 1 

THE CYCLE IN AGRICULTURAL PRODUCTION 

Man is so constituted that he is too likely to think that present condi¬ 
tions are to continue. If we have a wet year or two, we think that it will 
always be wet; if good prices, these are to remain forever. In the case of 
prices, it is the very feeling of certainty that present conditions are to 
continue that makes it impossible for them to do so. One of the most 
important gifts for man to cultivate is his ability to forecast the future. 
This ability is one of the most valuable business assets. 

The usual guide that is followed in determining what crops and animals 
to produce is the profits of the last year or two, but since prices may be 
temporarily high or low, longer periods should be considered. Many 
factors are involved. The yields in the community may be good in a year 
of poor crops, or the community may have poor crops in a year of general 
overproduction and low prices. Add to these uncertainties the fact that 
the weather has nearly as much to do with the total crop as the acreage, 
and it is no wonder that the fanner finds it difficult to tell what acreage to 
plant. With the annual crops, the acreage is kept fairly close to the coun¬ 
try’s needs. The longer the time required to grow a product, the worse 
the periods of over- and underproduction become. A shortage of an annual 
crop may be made up in a year, but it takes ten to twenty years to adjust 
the area of apples and fifty to a hundred years to grow a lumber crop to 
supply a shortage in lumber. 

Apples in the Northeastern States are a good crop with which to illus¬ 
trate this point. If the supply of apples is short, prices will be high. If 
this condition continues for a few years, planting will be encouraged, but 
the trees planted will have no effect on the next year’s crop. Prices may go 
still higher and so stimulate more planting. This condition may continue 
for twenty years, after which comes the deluge of apples, with more trees 
coming on every year. This is what happened during the past generation. 
Apples paid well from 1854 to 1864. From 1864 to 1874 prices were very 
high. They continued fairly good till 1878. They then dropped and 
continued to drop till 1896, when thousands of bushels were not picked. 
Since 1896, prices have been rising, and for the last few years they are again 
so high that people are becoming wild about them. 

Nearly all the bearing apple orchards in New York were planted between 
1855 and 1878; planting then practically stopped. It has been much over¬ 
done. In the early nineties some orchards were cut down. 

In one township in Monroe County, New York, which is in the center 
of the apple belt, 57 per cent of the apple trees were planted from 1859 to 

1 D. H. Robertson, A Study of Industrial Production, pp. 13-14. 


/ 


UNCERTAINTY AND THE BUSINESS CYCLE 


77 

1878; only 11 per cent were planted from 1879 to 1903; while 21 per cent 
were planted from 1904 to 1908. 

From the figures thus far available, it appears that the periods of over- 
and underproduction of apples last about twenty to twenty-five years, as 
it takes this time to get enough trees raised to bearing age to cause overpro¬ 
duction, and about another equal period of little planting before prices rise 
high enough to stimulate another planting wave. It would appear to 
be the part of wisdom for a farmer to start planting or buying orchards 
about the middle of the low-price period when everyone is discouraged, 
and to stop planting at the time when prices are so high that everyone is 
planting. Some farmers do follow this practice. The farmer who planted 
in the eighties has already been rewarded. 

Hogs usually rise in price for two to three years and then drop for two 
to three years. A very abnormal corn crop shifts the hog curve. Since 
1866 the curve has been very regular until 1901, when the very short corn 
crop checked hog production, so that the drop in hog prices did not come 
until two years later. It takes about two to three years of low prices to 
check hog production and get rid of the extra pigs that are coming on, and 
about two to three years to get production started and‘the pigs raised to 
marketable age so as to again cause overproduction. If a farmer in the 
corn-belt changes his production on account of prices, it would appear to 
be good policy to raise a considerable number of pigs in the second or third 
year of low prices, and to be cautious about the number raised in the second 
and third years of high prices. When the majority are disgusted with the 
business is a good time to buy; when the majority are declaring that prices 
will never again be low is a good time to sell. 

Prices of horses show the same cycle, but it takes a long time to grow 
enough colts to overstock the market, apparently eight to ten years. Those 
who were first to start raising colts after the ruinous prices of 1896 made a 
good profit. When the price of horses drops very low, it would appear to 
be the part of wisdom to sell all the old horses and buy young ones that will 
still be living when prices rise. 1 

It will be noted that the fundamental reasons given by Warren 
for the fluctuation of the price of farm products is the same as that 
given by Robertson for the fluctuation of volume of the production of 
coal. In each case, the essential thing is the point to which reference 
was made above—the impossibility of eliminating the uncertainty 
which arises under conditions of competition, from one competitor’s 
ignorance of what other competitors are going to do. As Warren 
notes, “It would appear to be good policy to raise a considerable 
number of pigs in the second or third year of low prices ” and “ to start 

1 G. F. Warren, Farm Management , pp. 83-90. Copyrighted, The Macmillan 
Company. Reprinted by permission. 





78 


RISK AND RISK-BEARING 


planting or buying orchards when everyone is discouraged.” This is 
very good advice for the individual farmer, but it does not solve the 
social difficulty, for if everybody starts planting when everybody is 
discouraged, it is evident that nobody is really discouraged, and the 
result of a universally efficient attempt to concentrate production in 
the second or third year of low prices would be to insure a still further 
descent of prices. For the present it does not appear likely that such 
advice will be so universally accepted as to make its acceptance 
disastrous, but it is easy to see that the efficiency of such instruction 
depends on its own inefficiency. The problem is very much like that 
of spreading the Christmas trade. To induce people to do their 
Christmas shopping early is to confer a mutual benefit on the shoppers, 
the clerks, and the retailers, but if a prophet should arise to preach 
the gospel of early shopping with such fervor that everybody tried to 
do his Christmas shopping in the first week of November, the results 
would be disastrous. The prophet’s social value depends on the 
limitations of his own prophetic efficiency. 

In the case of the agricultural operations discussed by Warren, 
the cycle is a special cycle in the individual industry. In any line of 
competitive production where there is a large time element involved 
in the adjustment of the rate of production, this cyclical tendency 
shows itself. With regard to a large class of commodities, however, 
the conditions of production in one field have a direct bearing on the 
prosperity of producers in another field, so that the tendency is for 
the ups and downs of many of our most important branches of produc¬ 
tion to run together, giving rise to the phenomenon known as the busi¬ 
ness cycle. Transportation, manufacture of steel and copper, and of 
building materials, the production of luxuries for laborers’ consump¬ 
tion, the fuel industries, all are bound up very closely with one another. 
Financial institutions, such as banks, brokerage houses, and insurance 
companies find their prosperity directly dependent upon the activity 
of business in other important lines. In fact, outside the field of 
agriculture, a superficial examination of the facts leads to the con¬ 
clusion that prosperity and depression are phenomena characteristic 
of the entire business community rather than of individual trades. 
And even in agriculture, some influence of the business cycle is clearly 
to be seen, though it is often overshadowed by the influence of other 
conditions. There are however numerous industries which are almost 
immune from the cyclical tendency. 


UNCERTAINTY AND THE BUSINESS CYCLE 


79 


The following selection furnishes a more detailed analysis of the 
operation of the tendency to rhythm in the errors made both by 
producers of basic goods and by middlemen in the accumulation and 
liquidation of stocks: 

Every producer of things to be sold to producers has two demands to 
meet. He must maintain the industrial equipment already in use and the 
stocks of materials and goods on their way to the final consumer, and he 
must also furnish any new equipment that is wanted for new construction, 
enlargements, or betterments, and any increase in the stocks of materials 
and unsold goods. Both these demands come ultimately from the consumer, 
but they follow different laws. The demand for maintenance and replace¬ 
ment of existing capital varies with the amount of the demand for finished 
products, while the demand for new construction or enlargement of stocks 
depends upon whether or not the sales of the finished product are growing. 
Normally, over a long period of years, there is a certain demand for new 
construction on which producers can rely, and hence the demand for new 
construction is a normal part of any demand schedule for this kind of goods. 
But it does not come regularly. 

The demand for a certain product, let us say, begins to increase steadily, 
each year seeing an increment equal to io per cent of the original demand. 
At the end of five years the increase stops and the demand remains station¬ 
ary. If the productive equipment has kept pace with the need, it is now 
enlarged by 50 per cent and calls for 50 per cent more expenditure for 
maintenance and replacements. Meanwhile there has been an added de¬ 
mand for new construction equal in five years to half the entire original equip¬ 
ment. If renewals are at the rate of 5 per cent a year, the first effect of an 
increase in demand at the rate of 10 per cent in a year is to treble the de¬ 
mand for the means of production, since a demand for new construction has 
arisen twice as large as the previous demand for maintenance. 

What happens at the end of the five years when the demand stops 
growing ? By this time the requirements for maintenance are 50 per cent 
greater than they were while new construction has been going on at a rate 
equal to twice the original maintenance account. The total output has 
grown to three and one-half times its former volume. But the demand for 
new construction now ceases abruptly. This means that if the producers 
engaged in construction work had enough capacity to meet the demand 
of the fifth year the sixth year would see them running with four-sevenths 
of their capacity idle. 

Thus the law of demand for intermediate products states that the 
demand depends not only on the demand for the final product, but on the 
manner in which that demand is fluctuating. Making all due allowances 
for mitigating factors in translating the illustration back into real life, it is 



So 


RISK AND RISK-BEARING 


still difficult to see how the building and machine-making industries can 
possibly avoid the disagreeable experience of outgrowing themselves in 
time of prosperity. For demand can never be expected to grow at an 
absolutely steady rate, and the slightest fluctuation seems destined to put 
the producer of capital goods in a situation comparable to that of a passenger 
forcibly carried by his station. 

This principle may be illustrated by a town which grows rapidly up to 
the size at which its industrial advantages are fully utilized and beyond 
which its normal production can expand but slowly. When the point of 
transition is reached from rapid to slow expansion, the town may find 
that it has outgrown itself by the number of people engaged in the extra 
construction work involved in the process of growing. Houses to take them 
in, stores to feed and clothe them, trucks to haul the materials they work 
with, offices, etc., all will be demanded, and thus a boom may be created 
which is none the less temporary for being based on tangible economic needs. 

The chief reasons for keeping a stock are, first, to give the customer a 
wide selection of goods which he can actually inspect and, secondly, to give 
assurance of being able to fill large orders without delay. What is the 
effect of expanding demand on the amount of stock needed to fulfil these 
functions? Obviously, the larger the orders, the greater the danger of 
being sold out, unless the stock is increased in a corresponding proportion, 
or something not too far short of it. The increase in demand would not 
seem to make it necessary to keep any wider range of goods in stock. But 
if we are thinking, not of what is necessary, but of what is profitable, we 
have a different situation. Some goods which were just below the line of 
toleration will become profitable to handle on the basis of the increased 
rate at which they can be sold, and the natural result is the carrying of a 
greater variety of goods as well as the more goods of each kind. 

If the dealer is in doubt whether or not to keep a certain line in stock 
at all, a brisk state of demand will be likely to decide him to keep it. 

One other fact which may make merchants more willing to invest in 
considerable stocks is that a time of growing demand for some one com¬ 
modity, or a time of general increase in activity, are both times of rising 
prices for the intermediate products called for in the business affected. 
This makes these commodities a profitable investment so long as credit can 
be had on easy terms with which to enlarge one’s holdings. 

Taking all these things into consideration, one is justified in conclud¬ 
ing that an increase in demand naturally tends toward an increased invest¬ 
ment in dealers’ stocks, which is, if anything, more than in proportion to 
the increase in sales, unless limited by: (i) difficulty in getting added credit 
to carry the extra “working capital,” (2) an extremely sharp rise in supply 
prices, (3) the fear that the prosperity is temporary, or (4) the inability of 
manufacturers to make deliveries. 



UNCERTAINTY AND THE BUSINESS CYCLE 


81 


So far we have considered only one big division of the process. If we 
imagine the effect of all this on those industries which produce the tools 
and machinery used in the construction industry itself, we have a further 
possibility of multiplying the effects of a change in demand. In fact, the 
possibilities multiply with every step backward, for every industry which 
produces the means of production for some other industry has its own 
demand for its own tools and machinery to be filled. These possibilities 
of intensification are soon mitigated, however, by the fact that as we get 
farther and farther back we reach industries which produce machinery and 
tools for a large number of other industries at once, so that they register the 
effect of the average of a great many changes in a great many particular 
lines of production. Thus we finally reach the steel industry, which pro¬ 
duces the chief of all the raw materials used in making capital goods. This 
industry is so large that a change in the demand for any comparatively 
unimportant product, however much it may be intensified in the way we 
have just studied, has no appreciable effect on the great mass of steel pro¬ 
duction of the country. Only the largest industries buy enough steel to 
have a decided effect on the demand for this basic material. Railroading, 
which itself is to a very large extent engaged in the production of inter¬ 
mediate products, furnishes the steel industry with an outlet for its products 
which is so large as to be quite decisive and at the same time so fluctuating 
as to be a constant barometer of prosperity or of depression. And the steel 
industry itself is an equally important barometer, reporting in intensified 
form all general movements which originate with businesses closer to the 
final sale of the product. 

In summary, the main principles contended for are as follows: 

1. The demand for enlarging the means of production (including stocks 
of finished goods on the way to the consumer) varies, not with the volume 
of the demand for the finished product, but rather with the acceleration of 
that demand, allowance being made for the fact that the equipment cannot 
be adjusted as rapidly as demand changes, and so may be unusually scarce 
or redundant to start with in any given period. The demand for equip¬ 
ment may decrease as a result of this law even though the demand for the 
finished product is still growing. 

2. The total demand for producers’ goods tends to vary more sharply 
than the demand for finished products, the intensification being in propor¬ 
tion to the average life of the goods in question. 

3. The maximum and minimum points in the demand for producers’ 
goods tend to precede the maximum and minimum points in the demand 
for the finished products, the effect being that the change may appear to 
precede its own cause. 1 

1 Adapted by permission from J. M. Clark, “Business Acceleration and the 
Law of Demand,” Journal of Political Economy , XXV (March, 1917), 217-35. 


82 


RISK AND RISK-BEARING 


The principles explained in the preceding pages seem to be the 
basic causes of the business cycle; basic in the sense that they are 
adequate to account for a cycle without the presence of other factors, 
such as a particular monetary, credit, or profit-making system, to 
co-operate with them. On the other hand, given a cycle of production 
caused by the operation of the factor of uncertainty in the way just 
outlined, fluctuations in the level of profits, in the rates of interest, 
and in the stock of money must inevitably follow, and must in turn 
profoundly modify the problem of managing production. As was 
indicated in the earlier portions of this chapter, credit operates to 
exaggerate the violence of liquidation, or to check it, according as the 
principal creditors are well or ill organized. High prices, lagging 
wages, and lagging interest rates increase the level of profits and stimu¬ 
late further increases in productive activity. But it is easy to exag¬ 
gerate the influence of profit margins. Business men are willing to 
operate on a narrow margin of profit if the margin is sure, or reasonably 
probable, and an increased volume of orders, whether due to specula¬ 
tive accumulation or to pressure of actual consumers’ demand, even 
when the level of costs and prices is such as to make profits narrow 
and uncertain, operates to stimulate a quick expansion of output. 
Profit margins seem to result from, rather than to cause, the major 
changes in business activity. 

We may summarize the conclusions of this chapter as follows: 
The cycle is not merely a phenomenon of finance. The conditions of 
uncertainty under which production is carried on at the present time 
tend to create a rhythm of over- and underproduction in the case of 
many important industries. The fluctuation is more violent in the 
case of producers’ goods, because the cycle itself creates fluctuations 
in the demand for them which accentuate the fluctuations due to the 
alternate over- and underestimates of probable supply. The character 
of the cycle varies widely from one industry to another. Its character 
is influenced chiefly by the following considerations: 

1. The length of time required to adjust the rate of production to 
the state of demand. When production requires little antecedent 
preparation the cyclical tendency is at a minimum. 

2. The extent to which production is governed by factors outside the 
control of managers. 

3. The number of independent producers. In general, the larger 
the number of competing producers, the greater the difficulty in getting 


UNCERTAINTY AND THE BUSINESS CYCLE 


83 


information which will prevent the maladjustments which result in a 
cycle. 

4. The extent to which it is possible to store up the product for future 
needs. The more readily the product is accumulated, the greater the 
tendency to variation in the demand. 

5. The extent to which the particular line of production is independent 
of other lines in its activity. 


QUESTIONS 

1. Describe the conditions prevailing in a typical period of prosperity; of 
depression. 

2. Analyze the current business situation with a view to determining (a) 
what is the present phase of the cycle; ( b ) to what extent the present 
situation corresponds to that described as typical of this stage. 

3. What is meant by liquidation of credits? liquidation of inventories? 
Are the two processes sufficiently similar to justify our calling them by 
the same name ? 

4. Is liquidation of one of these two types (question 3) likely to cause 
liquidation of the other type ? Is the process more likely to proceed in 
one direction than in the other ? 

5. In heating a house by the use of an oil burner controlled by a 
thermostat, alternations of overheating and underheating occur, which 
are more marked if a hot-water heating system is used than with a hot-air 
system. Show how this difference illustrates a tendency operative in 
causing greater cyclical fluctuations in some types of business activity 
than in others. 

6. How do the following factors determine the extent to which a given line 
of business is affected by the cyclical tendency ? (a) the extent to which 
production is governed by factors outside the control of managers; ( b ) 
the extent to which the particular line is independent of other lines ? 

7. Which class of commodities have the more violent fluctuations in price, 
perishables or durable commodities? (Consider, first, fluctuations in 
price connected with the business cycle, and second, fluctuations due to 
maladjustments in the industry itself, due to non-cyclical causes.) 


CHAPTER VI 

BUSINESS FORECASTING 

Broadly interpreted, the term “business forecasting” might 
include practically the whole range of activities which aim at the 
elimination of business risk by the reduction of uncertainty. As 
was indicated in chapter iii, the range of methods used in business 
research is so great, and the problems are so much a part of the tech¬ 
nique of individual lines of business, that it is not practicable in a 
general work of this character to examine them in detail. One phase 
of the development of business research, however, touches so wide 
a range of enterprises and promises to be of so great importance for 
business in general that it may properly be given fairly detailed con¬ 
sideration. This is the technique of forecasting the coming and going 
of prosperity and depression, which is generally referred to as “busi¬ 
ness forecasting” in the narrower and more specific use of the term. 
The present chapter deals with forecasting in this narrower sense. 

During the last ten years there has been a great increase of interest 
in the problem of predicting the course of the business cycle, partly 
because the changes in business activity and in the level of prices have 
been of unusual magnitude and suddenness, and partly because the 
advance of economic science has made it possible to speak with more 
confidence concerning the main outlines of a technique of forecasting. 
The pioneers in the development of business forecasting were the com¬ 
mercial business service agencies, particularly the Babson Statistical 
Service and the Brookmire Economic Service. Within the past ten 
years, the problem has been attacked vigorously by academic students, 
notably by Professor Wesley C. Mitchell in his study of Business 
Cycles , more recently through detailed statistical studies by Professor 
Warren M. Persons and by the staff of the Harvard Economic Service. 
Commercial barometers, moreover, have multiplied, and financial and 
business periodicals have come to devote much space to analyses of 
the trend of business activity. 

Complete analysis of the causes which are making for change in the 
business situation would be by far the most satisfactory method of fore¬ 
casting if it were practicable. —Such an analysis, however, is wholly 
impossible. By this is meant not merely that a mathematically com- 

84 


BUSINESS FORECASTING 


85 


plete and exhaustive survey of all the facts necessary to such an analy¬ 
sis is impossible, but that even such an approximation as will serve 
the practical needs of business involves difficulties so great that at 
no time will the conclusions of competent students arrived at inde¬ 
pendently in this way be unlikely to be in substantial disagreement. 
Such an analysis would require a survey of the extent of existing stocks 
of goods held by producers, by middlemen, and by consumers, of the 
rates at which production and consumption were adding to, or sub¬ 
tracting from, these stocks, and of the ideas men held as to the desira¬ 
bility of increasing or decreasing these stocks or changing these 
rates of consumption and production. It would require also a more 
accurate knowledge than anyone can hope to attain of the future 
course of politics and of legislation, of the future of the weather and 
the consequent yield of leading crops, of the elasticity of consumers’ 
demand, of the tendency of fashions and changes in tastes, and of 
other factors so numerous and so elusive as to defy accumulation 
and comparison of the necessary data. 

A limited number of items may serve as an acceptable index of the 
general situation. —The overwhelming difficulties in the way of col¬ 
lecting the data necessary for a complete analysis of the business 
outlook at any given time may be overcome to a large extent by using 
the device known to statisticians as sampling. A limited number of 
items are chosen for careful study, and the remaining evidence is 
ignored on the theory that if the items chosen for study are really 
representative and are fairly numerous, no serious error is likely to 
result from treating the sample as though it were the whole body of 
evidence. This sample may be selected in either of two ways. The 
attempt may be made to pick out the most important causes of busi¬ 
ness changes, such as changes in crops, contraction and expansion 
of available supplies of credit, and taxation, keep close watch of them, 
and ignore the rest. Or, the course of past cycles may be studied to 
determine what statistical data have most faithfully reflected or pre¬ 
dicted the course of prosperity and depression in the past, and a num¬ 
ber of these items may be followed, the assumption being that the 
regularities which have shown themselves in the past may be expected 
to continue in the future, and that the use of a considerable number of 
indices will protect the observer against the danger of being misled 
by an accidental irregularity in the behavior of the items under con¬ 
sideration. 

Thus in the attempt to develop a technique for forecasting the 
course of the business cycle, two methods have suggested themselves, 


86 


RISK AND RISK-BEARING 


each of which is advocated in preference to the other by a consider¬ 
able number of students of business. These methods may be desig¬ 
nated as the method of economic analysis and the method of statistical 
comparisons. The method of economic analysis seeks to forecast the 
course of the cycle in exactly the same way that students of the social 
sciences generally try to forecast the course of events which are not 
cyclical in character. This method is simply to identify the forces 
which are making for contraction and those which are making for 
expansion in business, weigh the one set of factors against the other, 
and predict the course of events in the light of the relative strength 
of these opposing factors. No special attention to the cyclical char¬ 
acter of the fluctuations in business activity is involved, except that 
the forces engendered by any given stage of prosperity which make 
for change are recognized along with other factors which originate 
elsewhere. This method emphasizes the factors which differentiate 
every situation from those which have preceded it. 

The other method consists of a statistical study of the records of 
past cycles in the hope of establishing laws by which the course of a 
given cycle can be predicted by observing its progress and assuming 
that it will proceed as cycles have proceeded in the past. Advocates 
of this method urge that the regularities observed in the behavior 
of certain types of data are so great as to justify forecasters in assum¬ 
ing that these regularities will continue to show themselves in the 
future. 

Fundamentally, this is the method of all statistical science; the 
question of its validity in connection with this particular problem 
hinges on the degree of regularity in the behavior of the items studied, 
the length of time, or better, the number of complete cycles, through 
which the asserted regularity of behavior has been traced, the absence 
of known causes which may reasonably be expected to alter the 
sequence of phenomena in the future, and the availability and accu¬ 
racy of the necessary data. In the following sections, the leading 
barometric items are described, and their value for forecasting pur¬ 
poses is estimated. 

Fluctuations in prices are generally considered to constitute the central 
phenomenon of the business cycle . 1 —Interest centers therefore on 

1 For a survey of the literature of the cycle in which this point is developed in 
detail, cf. J. H. Williams, “The R 61 e of Prices in the Business Cycle,” Review of 
Economic Statistics, I, 206-10. 


BUSINESS FORECASTING 


87 


attempts to forecast the course of prices rather than to use them to 
forecast other phenomena. Indices constructed by averaging large 
numbers of prices, however, have few irregular fluctuations, hence 
a definite change of trend usually is interpreted to forecast a consider¬ 
able continued movement in the new direction. Prices may therefore 
be said without great inaccuracy to forecast their own movements. 

To show the trend of prices, averages known as index numbers 
are compiled. Of these, the most widely used are Bradstreet’s and 
the Bureau of Labor Statistics’ indices. Bradstreet’s index is obtained 
by simply adding together the prices per pound of ninety-six commodi¬ 
ties. This index is published monthly. The Bureau of Labor 
Statistics’ index is a carefully weighted average of over four hundred 
prices, each of which has been reduced to a percentage of the average 
price of the commodity for 1913. The Bureau of Labor index is 
much the more scientifically constructed of the two, but the difference 
in results obtained is not as great as the difference in methods of 
compilation would lead one to expect. Bradstreet’s index tends to 
precede the Bureau of Labor index in both its upward and its down¬ 
ward turns, because it contains a larger proportion of prices of raw 
materials. For this reason, it is somewhat more useful as a barometer 
of general business conditions. 

The volume of business done by the railways is a good barometer of 
general business conditions , though it tends rather to lag behind other 
indicators than to precede them. The figures generally used are those 
of railway gross earnings, idle cars, and car loadings. Of these, the 
car loadings are the most accurate and are also the earliest available. 
Unfortunately they are only available for the last few years. 

Gross earnings are a good indication of the amount of business done, 
provided care is taken not to overlook the effects of changes in freight 
rates. For example, the very great increase in railway gross income 
in the early fall of 1920 was due to the increase in rates and not to 
any increase in the movement of goods, except the normal seasonal 
increase. 

Railway earnings generally lag a month or two behind the course 
of general business on a downswing for the reason that goods which 
have been contracted for and goods which are drawn on the market 
under pressure to liquidate keep up the movement of freight during, 
and after, the crisis. After this movement has spent itself, the earn¬ 
ings fall off sharply. For instance, after the panic of 1907, which 
occurred in October, the earnings of ten leading railroads remained 


88 


RISK AND RISK-BEARING 


above normal until December, and were only 7 per cent below normal 
in January, but by July were 16 per cent below. Again in 1920 the 
decline of business activity was not reflected in the railroads’ earnings 
until late in the fall, though prices reached their maximum in the 
spring. 

Figures for net earnings of railroads receive a great deal of atten¬ 
tion, partly because increasing prosperity of railroads is apt to result 
in increased purchases of equipment and construction materials, and 
the volume of the railroads purchases is so great that anything which 
stimulates or depresses their buying is a major cause of prosperity 
or depression in any other lines. Another reason for the interest in 
railroad net earnings is the extremely wide investment interests in 
their securities, and still another is the fact that changes in freight 
rates forecast by the movement of railroad net earnings. Under 
the present law, it is the duty of the Interstate Commerce Commission 
to allow the railroads to collect such rates as will yield them a fair 
return (at present figured at 5J per cent) on the appraised value of 
their investment; hence a large increase in railroad net earnings 
creates hope of lower rates, and a decline in them dampens that hope. 

Idle car figures are not very accurate, as the number of roads report¬ 
ing varies and the figures are affected by activity in car-building and 
repairing cars, as well as by changes in the number actually used. 
In spite of these theoretical defects, the figures usually show much the 
same thing as the other transportation data, and no great risk is 
involved in using them if they happen to be more readily available 
than the more accurate indices. 

Industrial corporation reports furnish little barometric assistance .— 
If accurate data were available at any time concerning the volume 
of business and the profit margins at which the leading business cor¬ 
porations of the country are doing business, the information would be 
of incalculable value in gauging the outlook for good or bad business. 
A clearing-house for the free exchange of such information with 
power to compel full and accurate statements would be of very great 
service to its members. The impossibility of securing such an inter¬ 
change illustrates one of the disadvantages of a competitive system. 
Each firm has something to lose by imparting a full knowledge of its 
condition to its competitors, for even though it might gain much more 
than it would lose if it obtained full knowledge of their condition in 
the exchange, each would gain still more by securing the information 
from the others without making public the true facts concerning its 


BUSINESS FORECASTING 


89 


own condition, thus securng the benefit of the general publicity while 
protecting its own business secrets. This being the case, no firm is 
willing to be the first to abandon its policy of protecting business 
secrets and each would be suspicious of any other which offered to do 
so. The result is that business is done largely in ignorance of the 
extent to which competitors are piling up stocks of goods in anticipa¬ 
tion of the same demand, accepting duplicate orders and planning 
expansions which conflict with other producers’ calculations of the 
extent of the market and the supply of labor and raw materials which 
will be available for themselves. 

A possible way out of the dilemma is the imparting of confidential 
information to a public or private statistical bureau with the under¬ 
standing that the results will be published only in the form of totals 
or averages, or otherwise so treated as not to indicate the position of 
individual firms. Much progress has been made by various agencies 
in the last few years in obtaining the co-operation of business men in 
such endeavors. Examples are the studies of retailers’ costs made by 
the Harvard Bureau of Business Research; the data on volume of 
current production and stocks of goods published monthly by the 
Department of Commerce in the Survey of Current Business; and 
numerous surveys of particular industries published by trade journals. 
Open price associations have also done something to reduce the amount 
of uncertainty concerning the business outlook, but such organiza¬ 
tions find it diffcult to steer clear of the antitrust laws. Further 
progress along this line, it is to be hoped, will afford a better means 
than we now have for reducing the irregularities of business activity. 

Aside from the data given out in this way, the principal information 
available concerning the prosperity of individual corporations is 
found in the annual or more frequent reports of income and statements 
of assets, the reports of business failures, and changes of dividends. 
To each of these, consideration will be given. 

The reports of industrial corporations concerning their activities 
are issued so infrequently, and, as a rule, so long after the period to 
which they refer that they are of little value as indices of the general 
business situation, though they are very valuable as records of the 
course which prosperity and depression have taken in the past. Even 
in the case of corporations which issue quarterly statements of earn¬ 
ings, the information is delayed to such an extent that it usually is 
of value only to investors or speculators who are dealing in the securi¬ 
ties of the individual corporation, and not to the student of the general 


90 


RISK AND RISK-BEARING 


situation. Moreover, the reports of corporations are so apt to be 
colored by the interest of the management in making a showing of 
prosperity or of poverty that they must be used with caution. 

The foregoing generalizations have no application to the railroads. 
Railway earnings are published monthly, and uniform accounting 
methods are prescribed by the Interstate Commerce Commission so 
that the results for different roads and for different periods are com¬ 
parable. 

Dividend payments are even less reliable than statements of net earn - 
ings as indications of business conditions , because changes in dividends 
lag far behind the changes in business conditions which cause them. 
This is particularly true of the relation of dividend increases to busi¬ 
ness recovery. Reduction or passing of dividends follows more 
promptly on a collapse of prosperity, but so far as the general situa¬ 
tion is concerned it tells only what is already known. Investors are 
of course very directly interested in the passing of dividends whose 
securities they own, but the action of one company is of little value 
as a forecast of what another company will do. 

Numerous increases of dividend rates and the declaration of extra 
dividends are often considered to be a sign of better days ahead, 
but such an interpretation is more likely than not to be incorrect. 
When business is increasing relatively few concerns find it good policy 
to make extra large disbursements. Rather they reinvest their earn¬ 
ings to provide facilities for taking care of their expanding volume of 
business. It is at the end of a period of prosperity when large profits 
have been accumulated and there is no prospect of their being needed 
for further expansion that good policy permits the declaration of 
abnormally large dividends. 

Moreover, the dividend policies of corporations seem frequently 
to be regulated with a view to promoting the interest of insiders in 
stock-market dealings, and extra dividends in the closing days of 
prosperity are an excellent device for strengthening the market until 
stocks can be distributed. 

Business failures are a useful barometer. —Monthly figures for com¬ 
mercial failures are published by Dun's Review and Bradstreet's , and 
these are quite widely reprinted. These are failures involving losses 
to creditors. There are no statistics of industrial failures and none 
for failures which result only in the loss of the owners’ capital. The 
figures, both those for number of failures and those for total liabilities, 
show a high degree of correspondence with the activity of general 


BUSINESS FORECASTING 


91 


business. Failures, which are at a minimum in the latest stages of 
prosperity, increase very suddenly, reach the maximum while liquida¬ 
tion is at its height, then decrease gradually through the following 
periods of depression, recovery, and prosperity. Since 1890 the pro¬ 
portion of concerns failing has ranged from .38 of 1 per cent in 1919 
to 1.32 in 1915. 1 

Bradstreet classifies its data according to the causes of failure, 
such as incompetence, lack of capital, competition, etc., giving annu¬ 
ally the percentage which is accounted for by each cause. The classi¬ 
fication has no apparent value for barometric purposes; indeed, it is 
so vague that most failures could properly be classified under two or 
more captions. There is a pronounced seasonal variation in the 
statistics, January having by far the most failures, and December 
ranking second. 

Business failures form a convenient and readily accessible indica¬ 
tion of the degree of prosperity. Their chief defect as a forecaster 
is that their increase comes abruptly at a time when liquidation is 
already obvious, while their decreases are so gradual that it is difficult 
to judge when the number is approaching a minimum. 

New security issues show some effect of the business cycle , but are of 
no particular interest as barometers. —In times of prosperity, stock 
issues predominate. In the earlier part of a depression, there are 
numerous bond issues designed to enable the issuers to pay off their 
bank loans. Many of these bond issues are of a highly speculative 
character. Later in the depression period, high-grade bond issues 
are brought out by strong corporations in order to refund short-term 
notes and callable bonds at the low rates then prevailing. These 
changes, however, merely reflect the changes in the rate of interest 
and in public confidence, and nothing is added to our understanding 
of the current situation by tabulating them for study. 

Statistics of the iron and steel trade are given a great deal of attention 
by students of the trend of business. —This is true because of the extent 
to which activity in the production of iron and steel is essential to 
activity in the production of almost everything else. Building of 
every kind, the construction of railways and of railway equipment, 
the manufacture of agricultural implements and of nearly all kinds 
of machinery, all make heavy demands on the steel capacity of the 
country, so that a marked increase or decrease in the activity of almost 
any industry is reflected in the orders for iron and steel. 

1 Dun’s Review , XXIX, 18-19, quoted by Jordan, Business Forecasting , p. 159. 


92 


RISK AND RISK-BEARING 


For recent years, statistics of this industry are available in great 
variety, but those to which most attention is given are the figures 
for the production and price of pig iron and the unfilled orders of the 
United States Steel Corporation. Of these, the most useful are the 
figures for pig-iron production. Pig-iron production conforms quite 
closely in its fluctuations to the movement of the business cycle as 
indicated by other barometers. Normally, its fluctuations are con¬ 
current with, or slightly in advance of, the major changes in prices. 
In the cycle of 1919-21, however, pig iron lagged far behind the course 
of general business, reaching a minimum in the autumn of 1919 and 
a maximum in the autumn of 1920, some eight months after Brad- 
street’s index in each case. This irregularity, at least so far as the 
low figure for 1919 is concerned, is to be accounted for by the strike 
in the plants of the United States Steel Corporation. 

Pig-iron prices move in fairly close conformity with the fluctua¬ 
tions in business, but they are so largely subject to control in accord¬ 
ance with the judgment of a few individuals that they are less trust¬ 
worthy as business indices than are production figures. 

The unfilled orders of the United States Steel Corporation, pub¬ 
lished quarterly from 1901 to 1910 and monthly since that date, move 
in close conformity to the changes in the production of pig iroh, 
normally, however, changing a trifle earlier. In theory, orders should 
be an earlier index of coming changes than production, but the number 
of unfilled orders is so affected by changes in the rate of production, 
quite apart from changes in demand, that the priority of movement 
is not uniform and the significance of the figures is not always clear. 

Agricidtural production gives no clear indication of the business out¬ 
look. —The influence of agricultural production is perhaps the most 
difficult factor to analyze in the whole problem of the coming and going 
of prosperity. The difficulty does not arise, however, from the lack 
of information, for we have not only excellent statistical data concern¬ 
ing the volume of output and the prices of leading agricultural prod¬ 
ucts but also frequent forecasts throughout the crop year, some 
compiled by private agencies and some by the Federal Department 
of Agriculture. The difficulty arises from the apparent lack of cor¬ 
respondence between the actual relations of agricultural production 
and business prosperity and the relations which economic theory 
lead us to expect. Nearly all those who have written on the subject 
of the business cycle have agreed in emphasizing the fundamental 
importance of crops in determining the prosperity of general business. 


BUSINESS FORECASTING 


93 


The generally accepted doctrine has been well summarized, for 
instance, by J. H. Brookmire: 

Crops affect business: (i) by directly determining the ability of the 
farmer to buy factory products, his annual purchasing power through 
crops amounting to about $9,000,000,000; (2) by indirectly determining 
the amount of merchandise which persons employed in manufacturing and 
mercantile lines and all other non-agricultural pursuits can purchase, for 
if they must pay high prices for food there will be less to spend for mer¬ 
chandise, and vice versa; (3) by determining the earnings of the railroads, 
for railroad traffic largely consists in hauling farm products or merchandise 
to be exchanged for farm products, and since the crops largely determine the 
ability of the railroads to buy new equipment and make improvements, it 
follows that crops thus indirectly determine the degree of prosperity in 
the iron and steel business, which is the basic industry of the country. 
Thus it is evident that activity in transportation, iron and steel, hardware, 
textiles and all other lines of business finds its stimulative source—its 
fountain-head—in the agricultural harvests of the country. Prosperity 
fundamentally depends upon the condition of the soil, and the business men 
of this country always adjust their commercial commitments to the pros¬ 
pects of the harvests to a greater extent than to any other one factor. 1 

Mitchell is less emphatic, but says, “good crops tend to bring 
prosperity and poor crops depression in the seasons which follow. 
But the numerous exceptions to this rule show that other factors 
often overbalance the effect of the harvests.” 2 

The theory above outlined seems sound. That abundant agri¬ 
cultural production is fundamental to the prosperity of the American 
people can scarcely be questioned, for nearly a third of our employed 
population are engaged in agriculture and a large proportion of the 
rest are in business which caters directly to the needs of the farmer. 
Moreover, more than half of the raw materials used in our manufac¬ 
tures are products of the farm. Short crops apparently mean hard¬ 
ship for the farmer, reduced earnings for the railroad, lighter employ¬ 
ment for the railroad workers, higher-priced and scarcer raw materials 
for the manufacturer, and higher costs of living for the people, with¬ 
out an offsetting gain for anyone. 

And yet it is impossible to find in our business history any con¬ 
firmation of such a view. Neither as cause nor as effect do the lead- 

1 J. H. Brookmire, “Financial Forecasting,” Moody's Magazine , XVI (1913), 

19-21. 

2 Business Cycles , p. 239. See also for similar views Jordan, Business Fore¬ 
casting , p. 80; Jones, Investments , p. 256. 



94 


RISK AND RISK-BEARING 


ing crops appear to be related consistently to the fluctuations of busi¬ 
ness activity. It is true that in 1879 and in 1891 a short crop sold at 
high prices on account of the foreign crop failure proved a direct and 
unmistakable stimulus to American business. In 1921, moreover, 
the business depression reacted so unfavorably on the position of the 
farmer through decrease in agricultural prices as to cause a startling 
curtailment in farmers’ buying, which in turn struck heavy blows at 
the prosperity of not only all mail-order houses, implement manu¬ 
facturers, and fertilizer companies, but of every line of business whose 
sales territory was in the West or South. But, as a rule, no such con¬ 
nection between crops and prosperity can be traced. The fluctua¬ 
tions in the curves of cotton, corn, and wheat production rarely coin¬ 
cide, and when they do, they do not forecast corresponding changes 
in general business. Cotton and wheat production were both unusu¬ 
ally large in 1898, declined greatly in 1899, and recovered in the years 
immediately following; improvement and prosperity were unbroken 
from 1897 to 1903. All the major crops declined in volume in 1903, 
and depression followed in 1904, but they all increased in 1906 to 
practically the highest figures known up to that time, and though 
they were somewhat smaller in 1907, were still above normal in that 
year, yet a severe depression began at the end of 1907. 

The explanation of this lack of harmony between the results of 
observation and those anticipated from the standpoint of theory is 
somewhat obscure. It must be remembered however that very large 
or very small crops of all the leading agricultural commodities seldom 
occur in the same year, so that a shortage in cotton is very likely to 
offset, to a large extent, the effect of a bumper crop of wheat, and 
vice versa. It must be borne in mind also that the purchasing 
power of the farmer depends not on the size but on the value of his 
crop, and that a rise in prices usually offsets part of his loss from a 
short crop. Indeed sometimes, especially in the case of cotton, the 
increase in prices more than offsets the loss in production. In 1914, 
an enormous cotton crop sold at bottom prices caused almost a col¬ 
lapse of the whole economic structure of the South, while in 1921 a 
short crop was hailed with delight as promising relief from the prevail¬ 
ing depression. This does not mean that the loss from short produc¬ 
tion is less than it would be if prices were not affected by the size of 
the crop. What the farmer gains by high prices someone else always 
loses; what he loses by short crops no one else gains. But the high 
prices do mean that the loss from short crops is in part shifted to for- 


BUSINESS FORECASTING 


95 


eign nations, in part diffused among a larger group in this country, and 
in part distributed into succeeding years through a reduction in the 
carry over. The loss from higher-priced raw materials is largely ab¬ 
sorbed in corporation profits without necessitating changes in divi¬ 
dend rates, or carried into prices of manufactured goods which are 
not finally sold until later years, and are in part sold abroad. 

The loss to the railroads from crop failure is genuine, but its impor¬ 
tance is much less than it was a generation ago. No important rail¬ 
road is now dependent solely on agricultural production for its traffic. 
Even such a highly specialized grain-carrying road as the Missouri, 
Kansas, and Texas collects less than one-fourth of its freight revenue 
from products of the farm. Moreover, such effect as the short crop 
does have is distributed through several years. Less labor is employed 
in transportation of crops in the year in which the shortage occurs; 
equipment purchases are more likely to be reduced in the following 
year. 

Thus throughout the industrial structure, the influence of several 
crop years gets averaged, some parts of the country and some lines 
of business feeling the effect of one year’s short crop while others are 
feeling the effects of another year’s good crop, and the effect on general 
business activity of any particular crop becomes so blurred that it is 
quite hopeless to try to draw any conclusions from the crops as to 
the outlook for business in general. 

All this is not to say, however, that the crop outlook is of no baro¬ 
metric significance. It simply means that the crops are among the 
things which cause one business and one section to prosper while 
another is depressed, rather than the things which determine the 
tidal swings of the market as a whole. Each business man has to 
study not only the outlook for business in general but also the factors 
which affect peculiarly the lines of business and the locality in which 
he is interested and make its outlook different from that of business as 
a whole. In this latter task, a study of the crop outlook is likely to be 
of primary importance. 

Stock prices have a high reputation as business barometers .—The 
stock exchanges of the country all publish daily retords of the high¬ 
est and lowest prices paid for each security, together with the number 
of shares sold, and numerous averages of the prices of selected lists 
of stocks are published by periodicals and financial services. 

In general, stock prices, particularly prices of industrial stocks, 
are among the first prices to rise and also the first to fall, in the course 


96 


RISK AND RISK-BEARING 


of a business cycle. It is for this reason that so high an estimate 
is placed upon their barometric significance. For instance, before 
the crisis of 1907 stock prices showed a downward trend from Janu¬ 
ary, 1906, and before the crisis of 1920 they turned downward in 
November, 1919. Likewise in 1904, 1908, 1915, and 1921 they 
turned upward from four to eight months before the appearance of 
rising commodity prices and increased business activity. 

Much caution is necessary in using stock prices as an index of the 
business trend, however, for the reason that the stock market has 
many minor fluctuations which are quite independent of the course 
of business in general. Hence it is necessary after a change in the 
trend of stock prices to wait for some weeks to see whether there has 
occurred a real reversal of trend or only a minor fluctuation. More¬ 
over, even the major changes in stock prices are not always followed 
by similar changes in commodity prices and business activity, though 
changes in business activity seem always to be preceded by similar 
changes in the trend of stock prices. For instance, in 1899 and 1900, 
in 1910, and in 1917 major declines in the stock market gave warning 
of similar declines in other indices of prosperity, but no such declines 
occurred. 

The most reliable and hence the most important group of business 
barometers is the group which relates to the money market. —Credit is the 
life-blood of modern business, and the banking system constitutes the 
circulatory apparatus through which credit is made available for the 
more directly productive parts of the industrial organism. Hence, 
irregularities in the operation of the banking system are as significant 
to the student of industrial ills as are irregularities in the pulse beat 
to the physician. 

Banking barometers fall into three principal classes: indices of 
the volume of business transacted, of which the clearings and the 
checks cashed are the most important; statements of the condition 
of the banks, including the weekly reports of the Federal Reserve 
System, the reports of the Comptroller of the Currency on the condi¬ 
tion of national banks, and the reports of state banks and trust com¬ 
panies; and finally rates of interest on various classes of loans. 

Bank clearings and check transactions furnish a measure of the activity 
of business in the country , hence are more significant as general business 
barometers than as indices of the position of the banks. For compari¬ 
sons extending over a considerable period of time, the best index of 
the volume of payments is the record of clearings. These figures 


BUSINESS FORECASTING 


97 


are collected by the Commercial and Financial Chronicle and by 
Bradstreefs. For the last few years the figures of individual debits 
at member banks have been collected by the Federal Reserve Board. 
This is the figure for the total number of checks cashed and other 
charges made against individuals’ accounts, and is a more accurate 
index than the clearings, which include only checks deposited in 
banks other than the ones on which drawn, and omit a considerable 
proportion even of these. When the individual debits have been 
collected for a sufficiently long period to make significant compari¬ 
sons possible they will presumably supplant the clearings for fore¬ 
casting purposes. There appears to be little difference in the direction 
and relative amount of the changes indicated by the two barometers, 
however. 

In using bank clearings as a barometer of general business, it is 
customary to omit the figures for New York City, on account of the 
large influence exerted on those figures by changes in the volume of 
speculation at the Stock Exchange. Outside clearings fluctuate, in 
general, in much the same way as pig-iron production, wholesale 
prices, and business failures; that is, they give a fairly consistent 
picture of the changes in the volume of business transacted, but do not 
anticipate changes in such a way as to give them any marked superi¬ 
ority over the other standard indices. 

Statements of condition of the banks are more difficult of interpreta¬ 
tion than they were before the introduction of the Federal Reserve System. 
—In former days, when the national banks were required to keep in 
their vaults a definite proportion of their deposits in lawful money, 
the surplus reserve over this requirement, particularly the surplus 
reserve of the New York banks, was regarded as one of the most 
sensitive barometers of financial weather. Since the introduction 
of the Federal Reserve System, attention has been shifted to the 
reserve ratio of the Federal Reserve banks. This item cannot be 
interpreted with the facility with which the surplus reserve of former 
days was interpreted, because of the extent to which the control 
of Federal Reserve credit resources is exercised in accordance with 
the judgment of a small number of individuals. If it were certain 
that the Federal Reserve Board would in the future be guided by the 
Federal Reserve ratio in determining its credit policy in the way that 
directors of competing banks were guided by their reserve ratios before 
the Federal Reserve System was established, the ratio of cash reserves 
to combined notes and deposits of the twelve banks would be better 


9 8 


RISK AND RISK-BEARING 


worth watching than any single index which can be obtained. But the 
Federal Reserve Board is a body with large discretion and has a 
responsibility to administer the affairs of the system with a view to 
the public interest rather than with a view to earning the largest 
profits consistent with safety, and the element of personal judgment 
makes their action difficult to forecast. So far, the rise and fall of 
the combined ratio has seemed to be their most important guide, 
but there is no assurance that it will continue to be so. 

Fluctuations in such items as total gold reserve, national bank 
notes outstanding, Federal Reserve notes outstanding, and data relative 
to fiscal operations of the government are now of little barometric 
importance. Total bills discounted is an item of more significance, 
as it shows the extent to which the banks are using the rediscounting 
privilege, and thereby indicates the extent to which interest rates 
in the near future are likely to be controlled by the policy of the 
Federal Reserve Board. Turnover of bank deposits is a new statistical 
item, collected by the Federal Reserve Board from a limited number 
of banks, which promises to be of considerable value as an index of 
business activity, but is not yet available for a sufficiently long period 
to make careful comparative study of its behavior feasible. 

The most valuable single indices of business conditions are found in the 
rates of interest. —This is true partly because of the abundance and 
accuracy of the data, partly because of the consistency with which 
changes in the money market precede changes in general business, 
and partly because the part played by money-market conditions in 
causing changes in prosperity is great enough to make it possible to 
make allowance for exceptional conditions more readily than is 
possible in using forecasters whose relationship to the phenomena 
forecast is purely empirical. 

Our statistical information in regard to the prices charged for 
the services of capital is very satisfactory. Data are available 
for a large number of kinds of financial transactions, and most of the 
information appears quite promptly, so that the external difficulties 
in the way of the forecaster are at a minimum in working with this 
type of barometer. 

The interest rates which receive the most attention from a baro¬ 
metric standpoint are (a) the yield on high-grade bonds; (b) the rate on 
prime commercial paper (i.e., notes bought from business houses by 
note brokers and sold to banks); (c) the rate on thirty-, sixty-, and 
ninety-day loans “over the counter” (i.e., direct by banks to their own 


BUSINESS FORECASTING 


99 


customers); (< d) the Federal Reserve rediscount rate; (e) the call-loan 
rate. 

The rates on brokers’ paper and those on short-time loans over the 
counter correspond very closely in the direction and time of their 
changes, so that one will serve as well as the other for forecasting 
purposes. 

In general, all interest rates rise very late in a period of improve¬ 
ment or prosperity, reach their maximum during, or soon after, a 
crisis, and decline only after the liquidating process is fairly well 
completed. Call loans show by far the widest range of variation, 
and change the most frequently. They have many ups and downs 
which are not connected with changes in the activity of business. 
Bond yields are at the other extreme, showing comparatively little 
change, as a rule, except in periods of very great change in business 
conditions. Rates on short-term paper are intermediate in character, 
and are excellent indices of the trend of business conditions. They 
move so late in the cycle as to forecast a turn of other indices in the 
opposite direction. When they turn definitely either up or down after 
a long trend in the other way, a change in commodity prices and busi¬ 
ness activity in the opposite direction may generally be expected within 
a few months. Bond prices are also a fairly good barometer. When 
the average price of a selected group of high-grade bonds changes the 
direction of its trend, there generally follows a like movement in the 
stock market, and less uniformly, there ensues a few months later a 
similar change in commodity prices and the volume of business. 

Changes in the Federal Reserve rediscount rate, i.e., the rate 
charged by the Federal Reserve banks to their members in rediscount¬ 
ing loans, are perhaps destined some day to rank as the most impor¬ 
tant indicators of the trend of money-market conditions and the 
consequent outlook for business prosperity, but we have had, as yet, 
too little experience with the Federal Reserve System to enable us to 
lay down any final rules for interpreting this index. The object 
aimed at in establishing the system was that most of the elasticity of 
credit in the banking system should be in a central reservoir of credit, 
so that the member banks would have to resort to this central agency 
in times of expanding business in order to take care of the increasing 
demands of their customers. In line with this purpose, it is held that 
any increase in rates or restriction of credit initiated by the Federal 
Reserve Board will radiate through the system and cause a corre¬ 
sponding rise in rates and curtailment of credit, which will check the 


IOO 


RISK AND RISK-BEARING 


expansion of business. It is the function of the Federal Reserve 
Board to keep an eye on the progress of business and check inflation 
before it reaches the point where a collapse is inevitable. Vice 
versa, in times when business is dull the Federal Reserve Board can 
supply a stimulus by lowering rates and encouraging expansion 
through a liberal rediscounting policy. 

To the extent that the banks of the country become dependent 
on the privilege of rediscounting their customers’ notes at the Federal 
Reserve bank, it is clear that there do exist great possibilities of con¬ 
trolling the course of business through control of the supply of credit. 
At the height of the boom in the autumn of 1919, it was announced 
that an increase in the discount rate could be expected in the near 
future, and this was apparently one of the important causes of the 
decline in stock prices which started in November of that year. The 
rate was actually increased in January and again in June of 1920, and 
it is generally believed that this action was one of the major causes 
of the commodity liquidation, which was evidenced by the downward 
turn of Bradstreet’s index in February of 1920, and of the credit 
collapse which followed. 

As our analysis of the cycle in chapter v has indicated, there is a 
considerable amount of exaggeration in this view, though it contains 
a large element of truth. The speculative accumulation of securities 
and commodities in anticipation of further and further increases in 
price, and the continuous expansion of certain types of productive 
capacity, could not continue indefinitely, and the decline once started 
was bound to gain momentum. But it was in the power of the Federal 
Reserve Board to hasten by positive action the downward turn which 
it could not prevent by keeping its hands off. 

On the other hand, the power of the Board to hasten the return of 
prosperity by lowering discount rates is not so clear. The rate was 
reduced twice in 1921 without stimulating any considerable increase 
in rediscounting, so that any effect the reduction had in stimulating 
business must have been sentimental. The difficulty in the way of 
stimulating a rise is very much greater than that involved in checking 
a rise. When business is active the banks are led to utilize their own 
resources and are put in a position of dependence on the rediscounting 
agency. In a period of depression, however, they have unused 
resources of their own, and are in a position to take care of a con¬ 
siderable increase in customers’ demands without borrowing. No 
matter how low the rate, they will not rediscount so long as their own 


BUSINESS FORECASTING 


IOI 


funds are lying idle. Hence a lowering of the rediscount rate is like 
an importation of gold in times when reserves are already superabun¬ 
dant, or an immigration of labor in times when our own labor forces 
are largely unemployed, or the opening of new land for settlement in 
a pioneer country where there is already good, free land. It has no 
immediate, direct effect; it only gives assurance that there are larger 
resources to be drawn upon in case of need. 

The call-loan rates are of no barometric significance except to 
stock-market speculators, and of very little significance even to them. 1 
Very high call rates precede, and still higher rates accompany, a panic, 
but there are many extreme fluctuations in call-loan rates which are 
not the accompaniment of important changes in business, so that con¬ 
clusions based on the call rates necessarily involve a large margin of 
error. 

The rates of foreign exchange do not constitute a reliable business 
barometer , but they deserve brief notice because so many people 
attempt to make barometric use of them. Under normal conditions, 
the rates of exchange reflect changes in the volume of payments to 
be made between countries, but these changes are rarely of any 
importance from the standpoint of the outlook for prosperity in this 
country. During and since the war, the European exchanges have in 
many cases been maintained by deliberate action of governments at 
certain levels, and where this is not the case they reflect speculators’ 
estimates of the financial and political prospects of European govern¬ 
ment rather than business conditions or prospects. This is not 
true of some of the neutral countries, but in the disturbed condition 
of European finances it is quite hopeless to undertake a business 
forecast on the basis of the evidence furnished by any type of foreign 
exchange. 

Numerous indices may be combined into a single “ composite barom¬ 
eter .”—There are so many kinds of business statistics, and it is so 
difficult to estimate the relative importance to be attached to each of 
them, that it has occurred to many students of business conditions 
to try to cut short the task of interpretation by combining the whole 
body of data into one or more averages. Their idea is that if proper 
weight is given to each item in constructing the average, the result 
will be a more dependable indication of the general outlook than will 
any single item. Such averages are known as composite barometers. 
Supporters of this method of studying the business outlook point out 

*The point is discussed more fully in chap. ix. 


102 


RISK AND RISK-BEARING 


that all use of statistics rests upon a process of throwing together, into 
a single class, items which are not exactly alike, and that making a 
composite barometer in which, for example, pig-iron production is 
combined with bank clearings, is only a step further than the combin¬ 
ing of different kinds of pig iron or the clearings of different cities into 
a single item. In the latter case, the items combined differ in some 
ways but are alike in the characteristics in which we are at the mo¬ 
ment interested, hence, we are justified in throwing them together; 
if changes in pig-iron production and in bank clearings actually do 
have the same significance for our problem, we are equally justified 
in combining them. It is of course important that the figures shall 
be so handled that each shall have its proper importance in compari¬ 
son with the others, but it is perhaps no more difficult to determine 
their relative importance for the purpose of making the composite 
barometer than it is to determine the relative importance to be ascribed 
to each item when they are studied separately. The composite 
barometer has the great advantage that once the averaging is done 
anyone can use the results without repeating the whole process of 
weighing and comparing the data. 

On the other hand, the differences between items always have some 
significance, and the more averaging we do the more details of the evi¬ 
dence we lose. How far it is best to combine data depends on the 
amount of time the users of the reports are willing to spend in com¬ 
paring items, and on the relative importance attached to the similari¬ 
ties and the differences in the data. No one can make anything out of 
a mass of raw statistics without some classification, while an excessive 
amount of combination squanders part of the evidence. 

In the construction of all such composite barometers, two adjust¬ 
ments are necessary. In the first place, allowance must be made for 
“seasonal fluctuation,” that is, the change which occurs regularly at 
the same season of year. In many cases, this allowance must also 
be made in interpreting data without the use of composite indices. 
For instance, in 1921, very gloomy predictions concerning the outlook 
for the finances of the railways were made in the press on account of 
the falling off in traffic during the winter months, disregarding the 
fact that most of the decline was to be accounted for as a normal 
seasonal tendency. 

The other correction which must usually be made is an allowance 
for the normal increase in the volume of business, which occurs from 
year to year with the growth of the country. For example, between 


BUSINESS FORECASTING 


103 


1903 and 1915, the production of pig iron in this country increased 
from 17,000,000 to 20,000,000 tons. Yet during this interval there 
were four years when the production was smaller than in the preceding 
year. Clearly we have to deal here with at least two distinct types 
of variation, the general increase running on from year to year, and 
the fluctuation which accompanies the coming and going of pros¬ 
perity. The correction of the statistics for this growth element is 
made by estimating the normal increase and converting the actual 
figures into deviations from this normal figure. In making a com¬ 
posite index, the trend may be removed from the composite figure, or, 
better, removed from each item separately before the average is com¬ 
puted. 

The earliest composite barometers in the United States were com¬ 
piled by commercial organizations whose business was the sale of 
statistics and advice to business men for their aid in deciding questions 
of business policy and especially investment questions. Of these 
barometers, the best known and the simplest is the “Babson Composit- 
plot,” published by the Babson Statistical Organization as one feature 
of an extensive business, investment, and speculative service. 

The “ Bab's on Compositplot” is based on the theory that “ action 
equals reaction .”—The “Compositplot” consists of a line drawn on a 
chart to represent the average of certain business items for successive 
periods, beginning with 1904, through which line is drawn another 
representing the normal growth of business for the same period, the 
area between the line of normal growth and the line of actual growth 
being heavily shaded. The interpretation of the “Compositplot” 
is that the formation of an area above the line of normal growth fore¬ 
casts the formation of an area of similar size below the line of normal 
growth, and vice versa. The construction of the chart has been 
described by its inventor, Mr. Roger W. Babson, as follows: 

In recent years there has developed a school of thought which bases its 
prognostications on what is known as the “area theory.” This area theory 
considers both the factor of time and the factor of intensity, or prices. 
Their prognostications of prices are based on the product of these factors 
of time and prices, or, in other words, on the area consumed. 

In short, this new school draws an oblique line, with a slope based on 
the normal increase in the nation’s volume of trade. Starting at a time 
when the business of the country is practically normal, such as early in 
1903, actual business conditions are plotted from month to month. This 
gives certain areas below and above this line of normal growth. 


104 


RISK AND RISK-BEARING 


This Composite plot, therefore, shows merchants the actual condi¬ 
tions existing at any given time and, on the assumption that these areas 
tend to be equal in area, not in shape, it aids them in forecasting future 
conditions by showing whether the next area may be expected above 
or below the line of normal growth and about how long before it will 
come. 

A little thought shows how reasonable is this theory and how it auto¬ 
matically adjusts itself to conditions the same as a “governor” on an engine. 
For instance, if prices increase twenty-five per cent above normal, it is not 
reasonable to think that they will continue to go up until they reach the 
last previous high price of one hundred per cent, irrespective of the time 
consumed, but it is reasonable to suppose that after prices have held this 
increase of twenty-five per cent for a period of four times as long as they had 
when selling at the previous high advance of one hundred per cent, that the 
time has arrived when logically they should fall. 

In other words, the theory is that business conditions, as a whole, can 
continue with “the throttle one-fourth open” about four times as long as 
with the throttle wide open; or, to word it another way, when conditions 
are “doubly prosperous,” said prosperity can last only one-half the period 
of time that it could if conditions were only moderately prosperous. This 
school believes that if the country would be willing to run along at a normal 
rate of speed so that the line for actual business would correspond with the 
line of normal growth, we would always have moderately prosperous con¬ 
ditions with a steady, slow advance. On the other hand, the higher the line 
for actual business rises above the line of normal growth, the shorter length 
of time prices will remain high and conditions abnormally prosperous. 1 

The “ Compositplot” is compiled in the following way: The 
actual figures for the data which enter injo the plot are reduced to 
“index figures” through the use of technical methods which are the 
invention of the Babson Organization. The data are then segregated 
into the following groups: 

Mercantile conditions 

1. Immigration 

2. New building 

3. Failures 

4. Check transactions 2 

Monetary conditions 

1. Commodity prices 

2. Total foreign trade 

3. Foreign money rates 

4. Domestic money rates 

1 Annals of the American Academy of Political and Social Science, xxxviii, 
180-83. (Philadelphia, 1911.) 

2 Check transactions substituted for bank clearings January 1, 1922. 



BUSINESS FORECASTING 


105 


Investment conditions 

1. Yield of leading crops 

2. Railroad earnings 

3. Canadian conditions 

4. Stock-market conditions 

Then the figures in each group are combined to give an index number 
which reflects the activity of business in general. 

After the index numbers are compiled and plotted it remains to 
locate the X-Y line, or line of normal growth, in order that the areas 
above and below the line may be compared. In doing this, bank 
clearings outside New York City are used as an indicator, but the 
trend shown by the clearings is modified by observation of the other 
data. As the compilers have stated it: 

As it is always dangerous to use one subject alone, especially a subject 
reflecting surface movements, it is necessary to take bank clearings as an 
indicator only, and to check conclusions based upon it, at the end of each 
year, by all the important barometers of wealth which report annually; 
and again, at the end of each cycle, by the area of the Compositplot. 
In other words, we endeavor to rely only on our statistics in locating this 
X-Y line and thus far we have usually been able to do this, but we frankly 
assume that the areas should be equal. Therefore, this chart does not 
prove that the law of action and reaction applies to business, but rather 
assumes it. 

The location of this line is fundamentally based on the assumption that 
action and reaction are equal when the tolal force involved is considered, 
which force may be expressed graphically by an area. If this assumption is 
correct, the sum of the areas below the line of normal growth must approxi¬ 
mately be equal to the sum of the areas above the line of normal growth; 
and by the law of averages all of the areas tend to be approximately equal. 
In other words, if the law of equal reaction is applicable in economics as in 
every other science, then our line is located with sufficient correctness; 
on the other hand, if this law of action and reaction does not apply to 
economics, then of course the Area Theory cannot be relied upon for fore¬ 
casting business changes and these areas are of use simply as a general 
bird’s-eye view of conditions. At the end of the last cycle, however, no readjust¬ 
ment was necessary to make Areas “ D” and “E” equal. This fact is a most 
interesting testimonial for the Area Theory. 

It appears from the foregoing discussion that the so-called line 
of normal growth does not in fact represent merely the normal growth 
of the country, irrespective of temporary conditions of prosperity and 
depression, but is itself in part an expression of the prosperous or 


io6 


RISK AND RISK-BEARING 


depressed state of business at a particular time. This throws some 
doubt on the propriety of using the X-Y line as a base from which to 
measure areas representing the extent of prosperity or depression. 

A more serious defect of the Babson chart, however, from the 
standpoint of scientific method, is the lack of satisfactory proof of 
the fundamental principle of “action equals reaction.” It may be 
true that “the law of action and reaction applies to economics and 
human relations, en masse , as it applies to mechanics.” The facts 
available are not conspicuously inconsistent with the theory. But 
there has been no satisfactory investigation to determine the weight 
of evidence in favor of the theory, and it cannot at present be regarded 
as more than an interesting hypothesis. Until such research is accom¬ 
plished, students of social science will remain skeptical of the validity 
of forecasting methods which depend on its detailed application. 

The Broohnire barometers combine data which have been classified 
according to the sequence 0} their fluctuations. —The theory of forecasting 
upon which the methods followed by the Brookmire Economic Service 
are based, instead of combining all the statistical data into a single 
index, postulates a chronological sequence of business events, and 
combines only those which tend to fluctuate at the same time. The 
data for most of the barometric indices constructed by this service 
have therefore been selected because movement in them occurs in 
point of time prior to some price index or other statistical factor 
which it is desired to forecast, rather than in an attempt to portray 
the entire field of business conditions in a single picture. The Brook¬ 
mire organization claims that one great fundamental factor which 
James H. Brookmire, the founder of this service, brought as a new 
contribution to the science of business forecasting was the con¬ 
ception that changes in financial and business conditions do not all 
occur at one time but do occur in a chronological sequence. 

Both seasonal variation and secular trend are mathematically 
eliminated from the data used in the final presentation before they 
enter into the Brookmire barometric chart. Of the many barometric 
charts which have been constructed in seeking statistical measures 
which move prior to many factors which an economic service seeks to 
forecast in its regular work, only the two which are now being pub¬ 
lished and one important forerunner will be described. 

“Barometer No. i” is a chart which is intended to forecast the 
movement of industrial stock prices and of commodity prices. The 
theory of the barometer is that whenever the forecasting line turns 


BUSINESS FORECASTING 


107 


upward, industrial stocks will rise almost at once and commodity 
prices about six months later than industrial stock prices, with the 
qualifications (a) that the change in commodity prices is more accu¬ 
rately forecast by the turn of the stocks than by the turn of the 
forecasting line and ( b ) that in cases where the upward or downward 
movement of stock prices reverses itself within six months, the 
corresponding movement of commodity prices is likely to be too small 
to be of any practical importance. The forecasting line is a mathe¬ 
matical composite of the following six factors, each given the weight 
“which past experience indicates that they really have” in every 
change of business and investment conditions: 

1. A combination of industrial and railroad stock prices. These 
are included on the theory that when stocks are selling at higher 
than average prices they are likely to move downward, and vice versa. 

2. Physical volume of commodities coming into the market. 
Eight measures of volume are used to test this factor. The theory 
is that accumulation of excess stock is likely to lead to liquidation, 
and shortage is likely to lead to increased production. 

3. The ratio of merchandise imports to merchandise exports. 
Exceptional imports are considered to be equivalent to exceptionally 
heavy volume of production. 

4. 'Turnover of bank deposits. 

5. Commercial paper rates. 

6. Interest rates in London. 

“ Barometer No. 2” is a similar forecasting line which is intended 
to forecast the movement of the prices of bonds and of railroad stock. 
This barometer is constructed in the same way as Barometer No. 1 
except that commodity prices are introduced as a seventh factor, on 
the theory that advancing prices of commodities are unfavorable to 
bonds and to railroad stocks. 

» 

Notice should also be taken of a chart formerly published by the 
Brookmire Service, “The United States Barometer Chart,” which 
is important as a forerunner of the chart now published by the Harvard 
Economic Service. This chart contained three factors, which were 
plotted separately: (1) the index of banking funds; (2) the index of 
security prices; (3) the index of general business. It was stated that 
these three graphs moved in chronological order, the banking index 
rising first, followed by the stock-market index, and finally by the 
business index. A great rise in the business index, in turn, produced a 
fall in the banking index, and this was followed in turn by the stock- 


io8 


RISK AND RISK-BEARING 


market index, and the business index, and the cycle was ready to 
start again. 

The banking index was based upon (a) the total cash and reserves 
of New York clearing-house banks; (b) the percentage of these reserves 
to loans; (c) the percentage of loans to deposits; (d) the rate on first- 
class commercial paper in New York ( b , c, and d reversed in sign). 
The index of security prices was an average of prices of thirty-two 
leading stocks. The index of general business was based on bank 
clearings, railroad earnings, pig-iron production and prices, commodity 
prices, imports, building, and immigration. 

This sequence, it will be noted, is practically that which was indi¬ 
cated as typical in an earlier section of this chapter, and has in most 
respects been verified by the investigations of the Harvard Committee 
on Economic Research. The introduction of the Federal Reserve 
System and the restriction of immigration, however, have destroyed 
the former relationship between certain of the items. 

The Harvard “Index of General Business Conditions” represents 
the most ambitious and painstaking effort yet made to establish a 
relationship between the coming and going of prosperity and the fluctua¬ 
tions of selected data which may be used as forecasters .—This index was 
developed by the Harvard Committee on Economic Research and is 
published in the Review of Economic Statistics and in the Harvard 
Economic Service. 

In brief, this investigation is an attempt to apply the method 
utilized at an earlier date by Brookmire, of classifying the data with 
respect to the time of their typical fluctuations, putting into one group 
those items which tend to move ahead of changes in the volume of 
general business, into a second those which serve as thermometers 
reporting the activity of business at a given time, and into a third 
those which generally lag behind; then combining those which move 
together into a composite index so that the effect of accidental varia¬ 
tion in one item may be reduced or eliminated. The movement of one 
index is regarded as a forecaster of the next. A more minute classi¬ 
fication into five groups has also been made, though the three-group 
classification has so far appeared to be most useful. 

The principal differences between this investigation and those 
which have preceded it, particularly Brookmire’s, are first, the much 
more elaborate and scientific methods used to get rid of the seasonal 
fluctuations and the secular trend, and second, the classification of the 


BUSINESS FORECASTING 


109 


data into groups according to the results of a very minute study of the 
order in which they have preceded one another in the past. 

Every effort has been made to treat the statistical data in an imper¬ 
sonal way so that the element of personal judgment may be reduced 
to the minimum and the results may be the same that any scholar 
would get from the same data. The question whether one item 
typically precedes another in its rise and fall has been determined, 
not by analysis of the cause and effect relation between them, but by 
figuring mathematically the degree of correspondence between their 
fluctuations when they are compared as they occurred, then moving 
the record of one of them two, four, six, or more months ahead of the 
other and calculating the degree of correspondence again. The degree 
of correspondence is figured by the use of the “coefficient of correla¬ 
tion,’’ a device widely used in biological studies and introduced into 
social and business studies within the last fifteen years, chiefly by 
English statisticians. 

The validity of these mathematical methods of treating statistical 
data depends on the utilization of statistics covering quite a large 
number of cases, hence the choice of data is limited to those items for 
which comparable data are available over a long period. For com¬ 
parison involving annual data, only those items have been used which 
could be traced back in comparable form to 1879, while monthly 
data running back to 1903 have been considered sufficient. Seventeen 
series of annual data for the years 1879-1913 and twenty-three series 
of monthly data for the years 1903-16 or for longer periods were 
included. The twenty-three series are as follows: 

1. Bank clearings of New York City 

2. Tonnage of pig iron produced in United States 

3. Bank clearings outside of New York City 

4. Bradstreet’s index of commodity prices 

5. Imports of merchandise into United States, values 

6. Values of building permits issued for twenty leading cities 

7. Gross earnings of ten leading railroads 

8. Number of shares sold on the New York Stock Exchange 

9. Unfilled orders of United States Steel Corporation 

10. Tonnage, less lake traffic, of vessels entered in the foreign commerce 
of the United States 

11. Bradstreet’s number of business failures 


no 


RISK AND RISK-BEARING 


12. Rate of interest on ten American railroad bonds 

13. Rate of interest on four to six months’ commercial paper 

14. Rate of interest on sixty- to ninety-day commercial paper in New York 

15. Rate of interest on call loans at the New York Stock Exchange 

16. Bureau of Labor Statistics’ prices 

17. Dividend payments 

18. Prices of industrial stocks 

19. Prices of railroad stocks 

20. Incorporations in eastern states 

21. Loans of New York banks 

22. Reserves of New York banks 

23. Deposits of New York banks 

The first step in the analysis was the isolation of the various types 
of fluctuation which are found in the data. As a working hypothesis, 
these were considered as fourfold: (1) A long-time tendency to 
increase or decrease, which in technical language is termed the secular 
trend; (2) a cyclical movement superimposed upon the first, the 
extremes being found in periods of prosperity and depression; (3) a 
seasonal movement within the year; and (4) irregular variations. The 
four types of fluctuation are however not uniform in the different 
series, and in consequence individual treatment of each series was 
required. It became necessary first to measure the secular trend. 
This was accomplished by “fitting” a straight line or curve to the 
graph representing the original series. For example, in treating 
bank clearings, a dot was placed on a chart so that its distance from 
the base indicated the volume of clearings in a given year, the years 
being measured off in equal spaces from the left side of the chart. 
It is obvious that if the increase in clearings were exactly the same 
in each successive year the dots would all lie on the same straight 
line, and the slope of this line would indicate the rapidity of the 
increase in bank clearings. The method of “curve fitting” consists 
in drawing a line so that it comes as near as possible to passing through 
all the dots. This can be done with great accuracy by the use of 
mathematical formulas. The slope of the fitted line is considered to 
measure the secular trend or normal growth, and the deviation of the 
dots from the line to measure the fluctuation not due to growth. The 
assumption is that a rate of growth, shown by examining data of a 
number of years in the past, will continue to be the rate of normal 
growth in the future, so the line is carried forward with a uniform 


BUSINESS FORECASTING 


III 


slope. It is recognized however that this trend can really be deter¬ 
mined only for the past period, and in certain cases may by no means 
afford a good basis for estimating future trend. 

The determination of normal seasonal variation in the data was 
next undertaken. The method used is very involved and may con¬ 
veniently be divided into the following steps: (i) Relative figures 
are first calculated expressing the absolute figure for each month as a 
percentage of the absolute figure for the previous month; (2) medians 
of the month-to-month percentages are then calculated for each of the 
twelve months. The median is the item midway of the series. Thus 
it was found that in twenty-four years the business failures reported by 
Bradstreet’s for April ranged from 77 per cent to 117 per cent of the 
figures for March of the same year, but that in half the years the per¬ 
centage was less than 96 and in half more than that figure. Ninety- 
six per cent is therefore considered the typical ratio of failures for 
April to those for March, though it appears that in no year was the 
percentage exactly 96; (3) the medians are expressed as a continuous 
series using January as base; (4) they are then adjusted so that the 
discrepancy between consecutive January relatives (due to the secular 
trend) is o; (5) they are changed to a new base by dividing each item 
in the fourth series by the arithmetic average of that series. These 
adjustments are technically necessary in order to get the results into 
a form to use them as corrective factors. 

The series of items is modified by this seasonal corrective factor, 
and the resulting series gives the data with the influence of both secular 
trend and seasonal fluctuation eliminated. This is done as follows: 
Each of the “monthly ordinates of the secular trend” is multiplied 
by the index of seasonal variation for that month, obtained in the 
manner stated above. In other words, the line which depicts the 
normal growth of the item from year to year is modified so as to repre¬ 
sent the normal growth plus or minus the normal seasonal fluctuation. 
The normal monthly figures obtained in this way are then subtracted 
from the actual figures and the result is a series of figures representing 
the deviation of the movement of the item, bank clearings, for instance, 
from what it would be if it were affected only by seasonal factors and 
the growth of business. 

This series of deviations comprises the fluctuation due to the busi¬ 
ness cycle and also the irregular fluctuation caused by conditions 
special to the particular business from which the data are drawn. 
No attempt is made to separate the irregular from the cyclical factor, 


112 


RISK AND RISK-BEARING 


but it is assumed in combining the data into a composite index the 
irregular changes in each separate series will tend to disappear and the 
general average will reflect the effect of conditions common to all 
lines of business, that is, of the coming and going of prosperity and 
depression. 

Before the comparisons can be made, one other correction is 
necessary. Some of the series fluctuate widely, for instance, pig-iron 
production and call-loan rates. Others have a very narrow range of 
fluctuation, for instance, the yield on railroad bonds. Each series 
is therefore divided throughout by a figure representing its own aver¬ 
age deviation from its own average. This makes the average fluctua¬ 
tions equal and facilitates comparison of the time of the fluctuations, 
which is the only thing we are interested in. 

For technical reasons the standard deviation, which is the square 
root of the sum of the squares of the deviations divided by their 
number, is used rather than their simple average. 

It was found that the series fall into three quite distinct groups 
when arranged in the order of their fluctuation. There were variations 
within the groups, particularly the middle one, but the degree of corre¬ 
spondence in each group was much greater than the difference between 
the groups so that the classification was unmistakable. The series 
which fluctuate first, either upward or downward, are all series depend¬ 
ing upon investment and speculation, such as the average price of ten 
railroad bonds, the average price of industrial and of railroad stocks, 
the volume of sales on the New York Stock Exchange, and New 
York clearings. This is the speculative group. 

The series in which the fluctuations follow or lag behind the 
fluctuation of the speculative group all have to do with business and 
industrial activity, such as pig-iron production, bank clearings outside 
of New York City, and wholesale prices. 

The third group, in which the items lag behind the business group 
in their rise or fall, are items having to do with the banking business. 
They consist of interest rates, variously classified, bank reserves, 
loans, and deposits. 

The final step in the preparation of the general index is to construct 
a curve portraying the combined data for each of the three groups of 
data. Curve A, representing the speculative group, forecasts by its 
rise or fall, a rise or fall in curve B, the business group; curve B like¬ 
wise by its changes forecasts corresponding changes in curve C, the 
money group; curve C by its changes forecasts opposite changes in 
curve A. 


BUSINESS FORECASTING 


1 13 

It will be noticed that in the final classification and utilization of 
the data, this system bears a striking resemblance to the Brookmire 
method which was described on page 106. The Brookmire system 
was based apparently on observations and economic analysis; the 
Harvard system based on minute impersonal statistical analysis gives 
a striking confirmation of its most important conclusions. 

The question next arises, what is the degree of success in forecasting 
by means of this system? For the period from 1903 to 1914, the 
curves show striking regularity. Both in the depressions of 1904, 
1908, and 1911, and in the prosperity periods of 1905-6, 1909-10, 
and 1912, the curves turn up and down in invariable order and with a 
high degree of regularity in the time interval between them. This 
was only to be expected, however, as the indices were made chiefly 
on the basis of the actual course of events during this period. For 
the period from 1914 to 1918, the index proved to be valueless. The 
fluctuations of the data were determined by the exigencies of war prod¬ 
uction and war finance to such an extent that the normal relationships 
of the business cycle were entirely obscured. No conclusion as to 
the value of the barometer could be drawn from such an abnormal 
period. 

For the years from 1919 through 1921, the charts ran quite true 
to form, thereby meeting their first real test. Curve A reached a 
maximum in October of 1919, curve B in February of 1920, curve C 
in July of 1920 and February of 1921. Curve A reached a minimum 
in July and October, 1921, curve B in May, 1921, and January, 1922, 
curve C apparently in September, 1922. 

In conclusion, it may be said that the confidence to be placed in 
such a mechanical forecaster is a question which as yet cannot be 
answered, except from the standpoint of theory; there is not evidence 
enough to prove or disprove its pretensions. It should be added, 
however, that the publishers of the Harvard Index do not claim for 
it infallibility. They point out that such factors as the establish¬ 
ment of the Federal Reserve System, the destruction of capital 
during the war, and the change of the United States from a debtor to 
a creditor nation make it impossible to rely implicitly on forecasts 
based on the compilation of precedents and make it necessary to 
' supplement the forecaster with the results of economic analysis. 
A similar attitude is taken by the publishers of the Babson and Brook¬ 
mire charts. The charts are furnished in each of these three cases 
as one feature of an extensive service, other features of which include 
discussion of the extent to which special considerations necessitate 


RISK AND RISK-BEARING 


114 

modifying the conclusions which might be drawn from the sequence 
of events in the past. 

NOTE 

SOURCES OF BAROMETRIC DATA 

The essential barometric data are easily obtainable. —The available 
sources of barometric data fall into three general classes: first, the publica¬ 
tions of government bureaus and of banks and other business institutions, 
which are available gratis or at nominal cost; second, the periodicals which 
deal with financial and business conditions; third, the special “business 
services.” 

Of the first class, there is a considerable number, of which the following 
are among the most valuable: the Monthly Review of Credit and Business 
Conditions by the Federal Reserve Agent of the Federal Reserve Bank of 
New York, the Federal Reserve Bulletin, the Survey of Current Business, 
published by the Department of Commerce, the Monthly Bulletin published 
by the National City Bank of New York. 

Of the periodicals, the weeklies are by far the most valuable for fore¬ 
casting purposes. The following are worthy of special mention: the Com¬ 
mercial and Financial Chronicle, the New York Times Annalist, Commerce 
and Finance, the Economic World, Bradstreets, Dun's Review, the Saturday 
edition of the New York Evening Post, the Chicago Economist. All these 
publish weekly summaries of most of the important data; a very brief 
comparison is sufficient to indicate which of them furnish the items in which 
one is particularly interested. 

For those who wish more complete and earlier information as to the 
trend of business conditions and are willing to pay for having the data 
interpreted as well as collected, a number of special business services are 
available. The Harvard Economic Service, the service sold by the Babson 
Statistical Organization, and the Brookmire Service have already been 
mentioned in connection with the subject of composite barometers. In 
addition to the barometers described, each of these services furnishes bulletins 
dealing with current developments and offers interpretations and forecasts. 

The Babson Service consists of a General Barometric Bulletin, contain¬ 
ing the “ Compositplot ” with brief comments and a few notes on important 
developments affecting business in general; a Buyers' Bulletin, on commodi¬ 
ties and prices; an Industries Bulletin, forecasting conditions in specific 
industries; a Sellers' Bulletin, which deals with business and credit condi¬ 
tions in specific localities all over the country; a special Labor Bulletin; and a 
Bulletin dealing with speculative securities and investments. The organiza¬ 
tion maintains a large statistical force, and furnishes a large amount of 
information concerning the general situation and also the specific details 
needed in modifying general conclusions to determine their application to 
the problems of the individual business. The Babson forecasts are very 
definite and specific. 

The Brookmire Service furnishes an Investment Opportunities Bulletin, 
a Speculative Bulletin, a Building Bulletin, a Sales and Credit Map, a Trade 


BUSINESS FORECASTING 


US 

Bulletin , and a Financial Bulletin. These bulletins cover somewhat the same 
general field as is covered by the Babson Bulletins, though as the titles indi¬ 
cate there are some differences of emphasis. Like the Babson Service, the 
Brookmire Service makes very definite and intelligible recommendations 
concerning the specific securities to be bought and business opportunities 
to be cultivated or avoided. 

The Harvard Service is relatively new, and represents the first effort 
on the part of an educational institution to enter the field of professional 
business advice. The principal features of the service are a weekly letter 
and monthly desk sheet, which include data of current barometric interest, 
both the actual figures and the items adjusted for seasonal and secular 
variation; the barometric curves discussed above and discussion of their 
significance; special articles dealing with current developments of impor¬ 
tance, such as foreign financial conditions, tendencies in trade, etc.; other 
articles which present the result of special investigations, such as the tend¬ 
encies of a particular industry during business depressions; and a quarterly 
publication, the Review of Economic Statistics , which contains more extended 
articles dealing with the theory and history of business cycles and kindred 
topics. The material published in connection with this service represents 
a very high standard of scholarship and has already included numerous 
valuable additions to our stock of knowledge of the phenomena of pros¬ 
perity and depression. There is no attempt to recommend specific invest¬ 
ments or details of business policy. 

QUESTIONS 

1. Show how the justification of the use of the sampling method in studying 
barometric data involves application of the law of large numbers. 

2. “The changes wrought by the war make it necessary to supplement sta¬ 
tistical comparisons with the results of economic analysis.” 

3. “Price changes may be said to forecast their own movements.” Explain. 

4. Compare the significance of railway gross earnings and of car loadings, 
as barometers of the volume of trade. 

5. Under what conditions might the management of an industrial corpora¬ 
tion have an interest in coloring the reports of the corporation to make it 
appear more prosperous? less prosperous? 

6. Does the fact that staple agricultural products are sold in a world-wide 
market affect the barometric significance of the volume of production 
in this country ? 

7. Why do cotton prices show more tendency than do wheat prices to rise 
greatly in years of small production in this country ? 

8. Under what conditions may a heavy importation of gold result in an 
easing of credit in this country ? 

9. “Rising interest rates forecast falling bond prices.” Why? 


CHAPTER VII 

RISK AND THE MANAGEMENT OF CAPITAL 

In no other field of business management does the factor of uncer¬ 
tainty absorb so much attention as in the investment 1 of capital. It 
is true that the control of production, the administration of labor 
relations, and the determination of market policies constantly involve 
the making of decisions on the basis of evidence which is not sufficient 
to establish the truth with scientific certainty, but they also involve 
to a large and increasing extent the application of scientific methods 
in the elimination of risk. In the investment of capital, on the other 
hand, it is nearly always the case that the final decision rests on proba¬ 
bility rather than on knowledge. The exceptional case is the case 
where the investor is interested only in securing absolute safety, and 
disregards considerations of yield, but this situation is very rare. 
Ordinarily the investor’s objective is to get something more than the 
yield which can be had on absolutely safe investments, and his choice, 
therefore, rests upon a balancing of the prospective profits against the 
degree of risk. In this paper, an attempt will be made to compare 
the various methods of securing a return on capital with reference to 
the amount and kind of risk involved in each. 

Opportunities for securing a return for the use of one’s capital 
fall into the following general classes: 

1. Investment directly in one’s own personally-directed business. 

a) Investment in new enterprise. 

b ) Investment in extension of the range or volume of business. 

c) Investment to reduce the costs or risks of business to which 
one is already committed. 

2. Repayment of one’s own indebtedness (to curtail outgo for 
interest). 

3. Deposit of money with banks, savings institutions, building 
and loan associations, purchase of insurance, etc. 

4. Purchase of securities with a view to obtaining income from 
interest or dividends. 

1 Except as otherwise noted the term “investment” is used in its original broad 
sense to designate all methods of putting money into enterprise, without the 
usual implication of safety . 

116 


RISK AND THE MANAGEMENT OF CAPITAL 117 

5. Personal loans, made for the sake of interest. 

6. Purchase or sale of securities, land, contracts, or commodities, 
with a view to profit from price changes. 

7. Gambling transactions. 

Let us examine these types of “ investment ” with a view to deter¬ 
mining the relative degrees of risk which they involve. 

1. The investment of money in one's own business affords illustra¬ 
tions of all possible degrees of risk. —Investments to start new businesses 
are nearly always speculative. The very fact that an opportunity 
has not been developed already usually means that its results are 
uncertain. As businesses grow older they become less speculative, 
more and more of their problems having been solved. Nevertheless, 
numerous risks assail nearly every type of enterprise, and it is not at 
all certain that business as a whole any more than pays its own 
interest and wages. Statistics of failures are available in the United 
States only for commercial, not for industrial, agricultural, or public- 
service institutions; these statistics indicate that the proportion of 
failures runs from one-third of 1 per cent in good years to nearly 2 
per cent in bad years. These figures, however, embrace only failures 
which cause loss to creditors; if we had data showing the number of 
businesses which fail to earn fair interest on their capital and wages for 
their owners the figures would doubtless run vastly higher. 

The investment of capital in one’s own business may offer an oppor¬ 
tunity for investment which is virtually free from risk, when its effect 
is to provide safeguard against risks already incurred. For instance, 
when $20,000 has once been invested in the equipment of a plant, 
$2,500 invested in an additional machine may return much more than 
normal interest through the addition it makes to the efficiency of the 
plant, and the risk may actually be decreased by the new investment. 
After the new investment $22,500 is at risk instead of $20,000 but the 
probability of total failure in the next season of poor business has been 
reduced by the increased plant efficiency, let us say from 8 chances in 
a thousand to 6 in a thousand. Whereas the risk before was mathe¬ 
matically equivalent to a cost of $160 per year, it now amounts to 
$133.50. The burden of the risk of total failure has been lessened by 
$26.50 a year, quite apart from the added income which will result 
from the decreased cost of operation in years of prosperity. 

2. The safest investment is the repayment of one's own debts. —When 
a debtor pays off his interest-bearing obligations he makes an invest¬ 
ment on which the return is the amount of interest saved. He incurs 


n8 


RISK AND RISK-BEARING 


absolutely no risk of losing his investment (unless the chance that he 
might otherwise evade payment be counted as creating a risk in 
repayment), nor does he run any risk of having his investment return 
to him and lie idle on his hands. Moreover, he pays no taxes on the 
investment (unless he was previously getting a deduction from his 
taxes on account of the debt). An absolutely safe, permanent, and 
tax-free investment of other types would net him from 3 to 5 per cent; 
this one will net him 6 or 8 per cent. The reason for this discrepancy 
is that the creditor’s charge for the loan includes a compensation for 
his uncertainty as to whether he will be able to collect his principal; 
he figures his claim as a more or less risky asset, while the debtor 
figures his liability as absolute. Thus the repayment of the debts 
relieves the creditor of a risk without creating a corresponding risk 
for the debtor. From the standpoint of risk, there is therefore a real 
social gain in the liquidation of debts. This may, of course, be more 
than offset by a loss in productivity, if the capital could produce more 
in the hands of the debtor than in the hands of the owner. 

3. Deposits with financial institutions are usually very safe .— 
Deposits of funds with banks, investments through building and loan 
associations and investment trusts, and the purchase of investment 
insurance and of annuities, if the institutions are honestly managed, 
offer an almost perfect assurance of safety, largely because their 
success depends on the success of a great number and variety of 
enterprises, some of which will almost certainly fail but the great 
majority of which will not, unless as the result of a collapse of the 
present organization of industry. An equivalent diversification of 
investments would, of course, obtain the same safety for the indi¬ 
vidual investor if he were able to secure it, but the financial institutions 
under consideration have the advantage in their ability to pool the 
resources of a large number of small investors and spread them over a 
much larger number of different investments than the average investor 
could include in his list. 

Moreover, such institutions are usually conservative in their 
choice of investments, and frequently are restricted closely by law in 
their selection. This is true especially of savings banks, which as a 
result are able to secure only a low return on their investments, but 
run very little risk. Some advantage is gained also by the specializa¬ 
tion of savings bank officers in judging the quality of investments. 
The chief advantage, nevertheless, is in the better diversification which 
is gained through the pooling of individual resources. Individuals 


RISK AND THE MANAGEMENT OF CAPITAL 


119 

whose income is large enough so that they can secure diversification 
in their investments seldom find it advantageous to use the savings 
bank. 

4. Investment in securities makes possible minute specialization in 
risk-bearing. —Incorporation is a device for making possible, among 
other things, a more minute specialization in risk-bearing than is pos¬ 
sible under the “ single entrepreneur ” system. The issuance of various 
types of securities makes it possible for the risk to be divided among 
a large number of specialists, each of whom takes only a small share in 
the risk of any particular business, and moreover takes in each business 
pretty much the kind of risk he chooses, some capitalists preferring 
to take preferred stocks or bonds offering a high degree of safety with 
comparatively low return, while others take common stocks which 
offer the possibility of larger return but a larger degree of risk. By 
varying the proportion of stocks and bonds and by special contract 
provisions, the risk can be divided in almost as many ways as there 
are investors. 

At the same time incorporation, by bringing in the principle of 
limited liability, cuts the bond between control and the bearing of 
risk, and makes it possible for the individual to invest his capital in 
lines of business concerning whose management he knows nothing, 
and in which he would never invest his capital if it were necessary 
for him to learn. This makes possible, of course, a much wider 
spreading of investments and a corresponding reduction of the indi¬ 
vidual’s risk of loss. This whole subject is well discussed by Pigou: 1 

So long as liability was unlimited, it was often against a man’s interest 
to spread his investments; for, if he did so, he multiplied the points from 
which an unlimited call on his resources might be made. The English Limited 
Liability Act of 1862 and its foreign counterparts enabled investments to 
be spread, without evoking this danger. Now, the spreading of invest¬ 
ments obviously means a combination of uncertainties on the part of all 
investors who hold shares in more than one company. But spreading, on 
the basis of limited liability, carries with it yet another element of com¬ 
bination. For, in general, each business deals directly or indirectly with 
many businesses. If one of them fails for a million pounds, under unlimited 
liability the whole of the loss falls on the shareholders or partners; but 
under limited liability a part of it is scattered among the shareholders or 
partners of a great number of businesses. Hence, any shareholder in one 
business combines with the uncertainty proper to his own business some of 
that proper to other businesses also. It follows that the range of uncer- 

1 Wealth and Welfare, p. 101. 


120 


RISK AND RISK-BEARING 


tainty, to which a normal ioo pounds invested in industry is subjected by 
reason of failures, is still further diminished in amount. 

High-grade bonds of industrial and public-utility enterprises offer 
a high degree of safety, chiefly because of the large margin which 
usually exists between the income required to meet charges on them 
and the normal income of the businesses, secondarily because they 
are usually secured by direct claims on assets of ample value. Here 
it will be noted that the risk against which the investor is protected is 
that of a partial failure of the business. If there is a complete col¬ 
lapse the charges cannot be met, unless out of accumulated earnings 
of the past, and ordinarily the assets pledged lose much of their value. 
All forms of security depend ultimately on earning power, and are 
subject to the hazards of the business in greater or less degree. But 
when the interest on a bond requires, say 25 per cent of the anticipated 
earnings, a shrinkage of 80 per cent in net means only a 20 per cent 
shrinkage in the amount available for interest, while a 60 per cent 
shrinkage leaves enough to pay the bondholder his interest in full. 
A complete failure wipes out the bondholder just as it does the stock¬ 
holder, unless the investment can be extricated and the assets applied 
to some other use. The probability of loss is thus roughly calculable 
on the basis of (a) the variability of the earnings, (b) the extent of 
the margin of safety, and ( c ) the degree of specialization of the capital. 
The same considerations apply to the purchase of real-estate mort¬ 
gages, and to loans to individuals. 

On the other hand, final equities, such as ownership of individual 
businesses or of common stocks of corporations, have their speculative 
character increased by the creation of prior liens. In the case cited 
above, the issuance of bonds sufficient to absorb 25 per cent of net 
income in fixed charges means that a 60 per cent shrinkage in net 
income cuts off 80 per cent of the stockholders’ return, and a 75 per 
cent shrinkage wipes it out entirely. The thinner the equity the 
greater the risk to both parties. 1 Common stocks, however, are 
always speculative, bven if preceded by no prior liens of any kind; 
for the accumulated assets and the prospects of earnings of any busi¬ 
ness, no matter how stable, are always changing, and the full weight 

1 That is, provided there is only one prior lien. The bigger the first mortgage 
bond issue the more the risk of failure to earn the interest, and the wider the relative 
range of fluctuation of the remainder. Issuing a junior lien bond does not as a rule 
weaken the first mortgage bond. 


RISK AND THE MANAGEMENT OF CAPITAL 


121 


of these changes falls on the common stock. Prior liens intensify 
the risk; they do not create it. 

In this connection a distinction may be noted between the customary 
adjustment of interest rates to risk in the market for long-time loans and 
in that for short-time loans. 1 In general, commercial money lenders do 
not make a charge for interest varying with the assumed degree of 
risk but establish a single rate and classify applications for credit 
into those which do and those which do not appear safe enough to 
be graded at this rate. In the investment market, on the other hand, 
there is an accurate adjustment of the interest rate to the assumed 
degree of risk, so that in the same market the rate of interest on bonds 
or other long-time securities varies within wide limits and adjusts 
itself to very minute differences in the security. 2 

5. The return to makers of personal loans is increased by the lack of 
general knowledge concerning the probability of repayment .—The busi¬ 
ness of loaning money to individuals and corporations with the 
expectation of early repayment, as distinguished from relatively 
permanent investment through the purchase of stocks or bonds, takes 
a wide variety of forms. Its most important form is the extension 
of credit to business men by banks, but it also includes the activities 
of private money lenders, discount houses, and loan sharks, and a 
vast amount of lending by individuals who are not professional 
lenders at all. In general it may be said that loans to private indi¬ 
viduals and businesses of moderate size are apt to yield a higher return 
in proportion to the risk of loss than that obtainable through invest¬ 
ment in securities. This refers, however, to the risk as estimated by 

• 

1 In the strict terminology of economics, interest contains no element of com¬ 
pensation for risk for the reason that all compensation for risk is treated as profit 
just as in the return of the business man for his own efforts the compensation for 
his services is treated as wages and “p r °fit:” includes only the return due to risk. 
In the ordinary language of business, however, this distinction is not observed. 
Interest is the return paid for capital invested under a control other than that of 
the owner for a stipulated return (or a charge against one’s own capital for the 
interest which could have been obtained by loaning it out). Commercial interest 
obviously varies with the estimated degree of risk. 

2 This difference is parallel to that existing between the practice in life and in 
fire insurance. In life insurance a single normal rate is established and most 
applications are either accepted or rejected, comparatively little attention being 
given by most companies to the adjustment of rates for sub-standard risks. In 
fire insurance, on the other hand, there is an adjustment of the risk premium to 
almost every conceivable degree of safety. 


122 


RISK AND RISK-BEARING 


the comparatively small number of possible lenders who are able to 
form an estimate on the basis of adequate information. The more 
widely known are the facts concerning the financial strength and 
reliability of the borrower, assuming that his record is good, the 
more closely will the rate he is obliged to pay correspond to the hazards 
involved in the business in which he is engaged. If the number of 
possible lenders whom he may approach is small, as is usually the 
case, he is less likely to obtain a favorable rate, simply because of 
lack of competition for his business. Moreover, the time risk to lenders 
is greater in short-time loans than in security investments, not only 
because the marketability of securities enables holders to withdraw 
their capital from them more readily, but also because short-term 
borrowers are more apt than are corporations to be slow in meeting 
their obligations, and extensions are more apt to be necessary. 

Loans secured by mortgages on real estate are generally considered 
the safest type of personal loan available for the ordinary lender. 
In most markets these yield a return very high in proportion to the risk 
of ultimate loss. They lack liquidity, and there is no adequate social 
machinery for securing a broad market for them. For those lenders 
who do not need a high degree of liquidity in their investments and 
are able to assure themselves of the quality of the mortgages offered 
them, they frequently form the ideal investment. It should be 
noted, however, that the return on such loans does not fluctuate as 
much as on most classes of investments, so that in periods of high 
interest rates other types of investment become relatively more 
attractive. 

Uncertainty as to time of repayment of loans is a source of risk .— 
The foregoing discussion has reference to the risk of loss of capital 
resulting from mistakes of investors and managers. Another risk is 
involved in investments of capital, however, the risk that one will not 
be able to get his capital back at the time he wants it even though the 
investment be perfectly good. From the standpoint of the debtor 
there is a similar risk in the possibility that he may be called upon to 
repay the loan at an inconvenient time. Every commercial crisis 
results in numerous financial embarrassments, arising on the one hand 
from unexpected failures to secure renewals of loans which have been 
counted on by debtors, and on the other hand from the failure of 
debtors to furnish promptly the funds which have been counted on by 
creditors. It is obvious that this risk, which for convenience we may 
call time risk , cannot be entirely eliminated so long as we employ a 


RISK AND THE MANAGEMENT OF CAPITAL 


123 


credit system, for if debtors are secure against having to repay 
advances at inconvenient times, creditors cannot at the same time be 
secure against the risk of failure to collect when they need the funds. 

All that can be done is to adjust the interest rate to fit the distri¬ 
bution of the risk. This is done in various ways. In ordinary bank 
deposits the time risk is all on the borrower—the bank must repay 
the loan on demand. Consequently depositors can expect little or no 
interest on their balances. In the case of a callable bond, i.e., a bond 
which may be called in for payment at any time the issuer chooses to 
do so, on the other hand, the time risk is all on the lender. So great 
is the advantage which this gives the borrower that callable bonds 
cannot be sold at ordinary rates of interest except by making them 
callable at a price somewhat above par. Ordinary call loans 1 can be 
terminated immediately at the option of either party. Such con¬ 
tracts exhibit the greatest variation in interest rates. Sometimes the 
condition of the market is such that the callability of the loan makes 
it very desirable from the lender’s standpoint, and call rates are very 
low. At other times the demand for such loans far outruns the supply 
and the rate runs up to figures never approached in any other type of 
loan. In long-time loans, such as bonds and mortgage loans, the 
contract cannot be terminated by either party without the consent of 
the other. Time risk is divided. Here again, as in the case of call 
loans, the rate charged depends on the condition of the market. 
Usually a large number of lenders prefer to carry the risk of wanting 
their money before they can get it rather than the risk of having it 
repaid before they want it on their hands. Consequently the rate on 
long-time loans tends to be low. When rates are expected to rise, 
however, the time risk is considered heavier from the lender’s stand¬ 
point on the long loans and from the borrower’s standpoint on the 
short loans, and rates on long loans are apt to be higher. 

Incorporation and the stock exchange make possible great reduc¬ 
tion in this sort of risk. By investing in a bond or share of stock 
which has a continuous market, the investor can gain most of the 
advantages of freedom from time risk which are afforded by call loans, 
while at the same time the issuing corporation is free from the incon¬ 
venience of sudden and unexpected calls for the return of the capital 
which it is using. Of course, the investor pays for this advantage. 
A security which is readily marketable will sell at a higher price, or, 

1 Such loans are common in this country only in the financial district of New 
York City. 


124 


RISK AND RISK-BEARING 


to state the same thing in another way, will yield a lower rate on the 
investment. Hence it is important for the investor to consider before 
buying a security whether he really needs the advantages of market¬ 
ability. If he does not, it is a waste of money to pay for it. 

6. Speculation on changes in prices is always risky. —It is easy to 
draw a distinction between “speculation” and “investment,” but it 
is impossible to define the terms with such accuracy that they shall 
never both be applicable properly to the same transaction. Col¬ 
loquially the terms are used to indicate degrees of recognized risk and 
no sharp line is drawn between them. The one shades off imper¬ 
ceptibly into the other, and there is a wide area of common ground 
along the border. Nor can we draw the line sharply so long as we 
seek an external test in the form of the transaction or the character 
of the enterprise. The only clear-cut distinction is a distinction as to 
the purpose: Is the transaction intended to obtain only a payment 
for the use of capital invested in an enterprise, with the outcome 
fully known and fully taken account of, or is there an attempt to realize 
an economic profit—to get more in return than we could if all parties 
to the transaction, actual and potential, were certain of its outcome ? 
In practice pure investment in this sense is rare; nearly every investor 
tries to combine safety with some degree of profit. 

Investment and speculation, whether in land, contracts, com¬ 
modities, or securities, involve much more exclusive attention to the 
problem of risk reduction than do most types of business activity. 
From the “shoestring” speculator, who tries to make a living without 
work by guessing the hourly fluctuations of the Curb price of an oil 
stock, to the president of a trust company, who shifts the proportion 
of railroad bonds and short-term paper in his holdings in accordance 
with his judgment of the future course of the interest rate, the whole 
army of investors and speculators are engaged in risk bearing; that 
is, in an attempt to profit by the uncertainty in other men’s minds 
and to get a better return for the use of their capital than they could 
if those from whom they buy and to whom they sell had as good 
knowledge of the present and as good judgment of the future as they 
themselves possess. 

Success in all these lines depends on ability to forecast price 
changes, which in turn depends upon ability to weigh the importance 
of complicated and conflicting indications of the movement of demand 
and supply, not with absolute accuracy, but with greater accuracy 
than someone else does it. All speculation on the price of anything is 


RISK AND THE MANAGEMENT OF CAPITAL 


125 


essentially a contest. For we cannot buy except at a price at which 
someone else considers the commodity or security a good sale, and 
we cannot sell except at a price which someone else considers to 
offer value for his money. Whatever the price is, that price repre¬ 
sents the consensus of market opinion at the moment as to what 
the price ought to be, and the attempt to make a speculative profit 
is a matching of one’s knowledge, judgment, skill, and luck against 
the composite judgment of the world. Risk is not merely incidental 
to this type of enterprise; it is of the essence. 

For this reason all speculative activity is often condemned by 
moralists as a species of gambling. Speculation is not a form of gam¬ 
bling; gambling is a form of speculation. All forms of speculation 
are attempts to secure profits, to get for the service of one’s capital 
(or labor) more than they are worth; that is, more than they would 
be worth if the relevant facts were generally known and account taken 
of them. 

7. Gambling is speculating on artificial risks. —The only thing which 
differentiates gambling from “legitimate” speculation (hereafter 
referred to for brevity’s sake as speculation) is that in speculation 
the risks are inherent risks of industry, and must be borne by someone 
if production is to go on. The speculator who buys a carload of sugar 
and holds it for a rise carries a risk which he need not carry, but which 
someone must; the more efficiently he judges the trend of the market, 
the less will the price fluctuations be. One speculator gains what 
another loses, but the gain of the first does not cause the loss of the 
second. 1 

In gambling, on the other hand, nothing of this sort is true. The 
risk is an artificial risk, created by the gambling transaction itself. 
Risk is increased for the sake of the risk and for the sake of profiting 
by one’s luck and skill at the expense of another. The losses of the 
unsuccessful are not compensated for by any gain to themselves, 
except the direct utility of the excitement. 

1 Indeed it tends slightly to decrease it. If A buys at the bottom and sells at 
the top, his operations make the bottom a little higher and the top a little lower 
than it would otherwise have been, and so reduce the losses of B, who buys at the 
top and sells at the bottom. However, it should be noted that this analysis of 
speculation is partial. Certain risks are increased by the fact that speculators have 
an interest in concealing the true situation from one another. Moreover, the 
inflation of the volume of trade through short sales multiplies the points at which 
risk appears. The whole question will be discussed more fully in a later section. 
See chap, xviii. 


126 


RISK AND RTSK-BEARING 


Except for the few who possess superior information concerning the 
probabilities of a favorable outcome , gambling enterprises involve a 
greater risk than is justified by the chance of profit. —We are not con¬ 
cerned at this point with the sporting type of gambler who engages 
in betting as a form of recreation and counts his losses a fair payment 
for the amusement he receives. Nor are we concerned with the pro¬ 
fessional gambling-house keeper who runs his game squarely and 
obtains his profit from a “percentage” in favor of the “house.” He is 
a business man engaged in selling amusement for a price, and so 
long as he plays the game squarely and the odds in favor of the house 
are known to his patrons, they have no cause to revile him for their 
inevitable final misfortunes. Finally, we are not concerned with the 
“gambler,” professional or otherwise, who creates a probability in 
his own favor by cheating. As in any other type of dishonesty, the 
man who is skilful is likely to find that the risks of his business and the 
social disapproval with which it is affected serve to keep down com¬ 
petition and make his profits relatively large. The point at issue here 
is the financial soundness of true gambling transactions, that is, of 
the staking of money on events whose outcome is uncertain, as a 
method of securing income. 

In such cases the gambler’s decision to risk his money on a certain 
outcome is determined by a consideration of the odds offered as com¬ 
pared with his judgment of the relative probabilities of the alternative 
possible outcomes. Gamblers as a class cannot win, but the indi¬ 
vidual gambler whose judgment is better than the average of the group 
whose decisions determine the odds is sure to make money in the long 
run; provided, first, that his stake in any one transaction is so small 
that no accidental adverse run cripples him; and, second, that he 
resists the temptation to enlarge his scale of operations after each 
successful venture and decrease it after the unsuccessful one. As a 
matter of fact, the probability of a given individual’s attaining success 
in an effort to make money continuously out of gambling transactions 
is of'very much the same sort as his chance of making money by 
taking advantage of any kind of price fluctuations. In the one 
case the prices, in the other case the odds, are the result of a composite 
judgment of the entire group of persons who are trying to profit 
by their forecasting skill; in each case success depends upon one’s 
relative ability to form a correct judgment as to the probability of a 
given outcome, relative that is to the ability of the rest of the group 
to form similar judgments. So far as the kind and degree of risk 


RISK AND THE MANAGEMENT OF CAPITAL 


127 


are concerned, the respective chances of the man who takes “flyers,” 
trusting wholly to his luck, the man who relies on the current gossip to 
obtain a basis of judgment, and the man who bases his operations on 
a careful study of all available information, are about the same in the 
wheat pit, the land market, the stock exchange, and on the race 
track. In each case, in the absence of “inside information” or of 
some method of controlling the outcome of the event, risk even to the 
most careful student is very great, while the chances of the average 
man’s attaining consistent success are negligibly small. 1 

QUESTIONS 

1. Are losses smaller in a diversified list of investments? Is risk less? 

2. “Gambling is a form of speculation.” Explain. 

3. What is the character of the “time risk” in a purchase of real estate 
mortgages ? in a purchase of well-known speculative stocks ? in a purchase 
of a life annuity ? 

4. Explain the relationship between limited liability and the diversification 
of investments. 

1 Attention is given to the social and moral aspects of gambling in chapter xviii. 
The methods used in analyzing the trend of speculative markets are considered 
in chapters ix and x. 


CHAPTER VIII 

THE SECURITY MARKETS 

As was indicated in chapter vii, the place in our business system 
where the attention of the profit-seeker is most closely centered on 
the problem of reducing risk through the elimination of uncertainty 
is in the field of speculation and investment. For this reason the sub¬ 
ject is given detailed attention in this and the following chapters. 
We will first survey the organization of the securities market and the 
technical devices used in speculative and investment operations. This 
will be followed by a survey of the methods used by operators in these 
markets in deciding when to buy and when to sell, chapter ix dealing 
with speculative operations and chapter x with those of a more con¬ 
servative character. Finally, in chapter xi we will examine the 
speculative markets for commodities, and the methods used in 
operating through them. 

I. THE MARKET EOR OLD SECURITIES 

The market for old securities presents the widest variation in char¬ 
acter. At the one extreme are the securities of thousands of corpora¬ 
tions for which there is no quotable market whatever. The investors 
who hold the stocks or bonds of these corporations are practically 
in the position of partners in the enterprises, so far as their ability 
to liquidate their holdings is concerned. At the other extreme, in 
marketability, are a dozen or more of the most active stocks which it 
is possible to buy or sell in lots of anywhere from one to a thousand 
shares with only a fraction of a per cent’s variation in the price. 
Between these extremes there are all degrees of marketability. 

The most conspicuous institution which has been developed for 
the purpose of facilitating trade in old securities is the stock exchange, 
and the market for active securities can therefore be understood best 
through a study of the organization and work of a typical exchange. 
The New York Stock Exchange will be described in considerable 
detail for the reason that its activities completely overshadow those 
of the other stock exchanges of the United States. Other exchanges 
will be described more briefly. 


128 


THE SECURITY MARKETS 


129 


The New York Slock Exchange is a voluntary association whose 
purpose is to facilitate the purchase and sale of securities by its members .— 
The fact must be emphasized at the outset that the Exchange is an 
organization formed by a limited group of individuals to advance their 
own business interests. Its principal function is to help its members 
to buy and sell stocks and bonds with the minimum expenditure of 
time and labor, and with the maximum amount of relevant informa¬ 
tion. to guide their decisions. Incidentally it renders numerous other 
services, not only for its members but for the public, but these other 
services are supplemental to, rather than independent of, its principal 
business. The Exchange itself does not buy nor sell securities, nor, 
except in rare emergencies, does it place any restrictions upon the 
prices at which trades are made, or influence them in any direct way. 
It is not its business to direct the flow of investment, nor to furnish 
the public with a barometer of prosperity, nor to protect speculators 
from their own folly or investors from the dishonesty or incapacity 
of the managers of their property. 

More specifically, the Exchange’s functions are the following: 

1. It furnishes a place of meeting for traders. 

2. It prescribes standard types of contract and rules of interpreta¬ 
tion, the provisions of which are implied in all trades made on the 
floor of the Exchange; and provides rules for conducting its business 
in an orderly way. 

3. It regulates the business methods of those of its members 
who are engaged in brokerage. 

4. It provides facilities for “clearing” trades, thus reducing the 
labor of delivery of securities and payment for them. 

5. It furnishes an elaborate equipment for obtaining and dis¬ 
seminating information. 

6. It attempts to influence legislation and the growth of public 
opinion in ways favorable to the interests of its members, and combats 
the activities of “bucket shops” and other agencies which tend to 
injure or discredit the business of legitimate brokerage, investment, 
and speculation. 

1. The Exchange furnishes a meeting place for traders. —The pro¬ 
vision of a place to carry on trade is perhaps the most important, as 
well as the earliest, function performed by an organized exchange. 
In an early stage of the development of a security market, brokers, 
dealers, and private investors can get in touch with one another by 
correspondence, by advertising, or by making the rounds of the 


130 


RISK AND RISK-BEARING 


financial district in person. Telephone and telegraph also still serve 
even in the largest markets to make possible an immense volume of 
trading without the use of an exchange. As the number of professional 
brokers in a city increases, however, it becomes desirable for them to 
get together for a part of the day to match their orders. A large 
office or the lobby of some convenient hotel may serve for a time as 
a meeting place. In New York the Broad Street Curb served for 
many years as a meeting place for dealers in certain stocks (see 
below, p. 147), while the original meeting place of the New York 
Stock Exchange was under a tree in Wall Street. Increasing numbers 
made it necessary in New York, as they have at many other points, 
to adopt some formal organization to share the responsibility and 
expense of maintaining a regular meeting place. 

2. The Exchange exercises control over trading .—Once the practice 
of meeting to trade is begun, it becomes necessary immediately to 
regulate to some extent the trade carried on in the common place of 
meeting. Hours of trading are prescribed, and penalties fixed for 
trading in listed securities outside these hours. On the New York 
Exchange, the present hours are from ten to three (on Saturday from 
ten to twelve), and outside trading (in listed securities) is punished 
by fines. The object of the penalty for outside trading is twofold: 
first, it insures to every member a fairer chance at other members’ 
offerings, and second, it restrains the severity of competition between 
brokers. 

The manner of executing trades is regulated in some detail. The 
standard unit of trading is 100 shares, and all bids and offers are under¬ 
stood to be for that amount, unless otherwise specified. Moreover, 
anyone who makes a bid or offer for a larger amount must accept a 
trade for 100 shares or any multiple thereof smaller than his offer. 
Offers not otherwise designated are understood to be “regular way,” 
that is, delivery and payment to be made on the next business day, 
except that deliveries on Friday trades are made on Monday. Trades 
may be made also for “cash,” that is, delivery and payment same 
day, or “seller three,” “seller thirty,” “buyer sixty,” etc., which 
means that the seller has three, thirty, or sixty days within which 
to make delivery, or the buyer to call for delivery, as the case may be. 
Such dealings are not frequent. 1 

1 During the early days of the Great War a great many sales were made “seller 
thirty” in order to allow time for importation of certificates. 


THE SECURITY MARKETS 


131 

“ Wash sales,” that is, trades where the buyer and seller are identi¬ 
cal, are prohibited, but the prohibition is difficult of enforcement, for 
the broker has usually no way of knowing whether his principal is 
also trading through another member. “Cornering” and other 
obvious ways of establishing an artificial price are also prohibited. 
All offers must be open for acceptance by any other member. 

3. Relations of brokers with customers are regulated. —The most 
important rule governing the relations of brokers and their principals 
is the stringent rule against cutting commissions, the object of which 
is obvious. There are also rules requiring the broker to make good 
to clients the losses resulting from errors on the broker’s part, and 
from failure to obtain the proper execution of orders; rules prohibiting 
the filling of orders from the broker’s own stock, and similar regula¬ 
tions designed to maintain the reputation of the Exchange as a home 
of fair dealing. 

4. Delivery of stock is simplified. —The delivery system of the 
New York Stock Exchange is one of the most efficient in the world. 
Its operation in brief is as follows: Since delivery of stock must be 
made daily, it is impossible for all transfers of ownership of active 
stocks to be recorded on the books of the issuing corporations. Stock 
certificates are transferable by indorsement, and in the case of active 
speculative securities certificates issued in the name of brokerage 
houses and indorsed in blank are frequently exchanged by mere 
delivery of the certificate. In the case of dividend paying stocks, 
this results in the dividends being paid to houses which are not the 
actual owners of the stock, and it is the business of the broker who 
owns stock at the time it “goes ex-dividend” to collect the dividend 
from the one to whom it is paid. In the case of non-dividend stocks, 
no inconvenience results from leaving the stock in “street name,” 
and frequently the stock is so left even when bought by investors and 
taken out of the market. 

The most important device for reducing the labor connected with 
the delivery of stocks is the Stock Clearing Corporation. This 
organization functions in two branches, known respectively as the 
night-clearing and the day-clearing branches. The night-clearing 
branch receives from brokers reports of the stock bought and sold 
during each trading day, and makes up a schedule of deliveries so 
that settlement can be effected with the minimum of labor. Thus, 
if A has sold a certain security to B, and B to C, and C to D, A may 
be directed to deliver the security direct to D. D will then make 


I 3 2 


RISK AND RISK-BEARING 


payment to A at an arbitrary settlement price which is established 
each day as a basis for that day’s settlements. If in the foregoing 
illustration A has sold, say, Southern Pacific stock at 90, B at 91, and 
C at 92, and the “settlement price” is 93, A will deliver the stock to 
D and collect $93 a share. The differences between the contract 
price and the clearing price are settled between the clearing members 
and the clearing corporation. A, having sold at 90 and collected $93, 
will owe the clearing corporation $3 per share. B, having bought at 
91 and sold at 92, will have a claim on the clearing house for $1 per 
share. C, likewise, has a claim for $1 per share and D, having bought 
at 92 and made payment at 93, has a claim to $1. The clearing 
house, therefore, collects $3 from A, and pays $1 to each of the other 
three. Thus, a member who has bought and sold the same amount 
during the day is relieved of all responsibility for delivery and pay¬ 
ment except the collecting of profits or the payment of losses, and an 
enormous saving of labor in the certification and payment of checks 
is effected. 

Systems substantially the same as this are used in most of the 
stock exchanges throughout the country. In New York, however, 
a unique feature was added in 1920, a second clearing system, known 
as the day clearing, for settling the balances due between traders 
who accept and deliver stocks. Thus, in the foregoing illustration D 
owed A a balance of $93 per share on delivery of the stock. Quite 
probably, however, A owed a similar balance to E on other transac¬ 
tions, E to F, and F to D. By reporting to the clearing house the 
balance due and paying in, or drawing out, the net balance of pay¬ 
ments, a second material reduction of the labor connected with 
check certification and deposit is effected. This second operation is 
worked out during the day following the delivery in the morning of 
stocks which have been bought and sold the previous day. This 
secondary clearing operation is unknown in the lesser stock exchanges 
of the country. 

5. The Exchange assists its members in securing information .— 
The Exchange’s service in providing its members with information 
consists chiefly of two activities, namely, the quotation service and 
the requirement of publicity from corporations whose securities are 
listed. The quotation service has been described as follows: 

In among the posts are four “pedestals,” each bearing the regulation 
“ticker” and a telegraph key. These are the sending stations of the great 
ticker service that records in brokers’ offices and banks all over the country 


THE SECURITY MARKETS 


133 


each sale of stock as it is completed on the New York Stock Exchange. 
When the Exchange has opened, we shall see scattered about the floor 
uniformed attendants, each wearing on his cap a broad gold band and a 
plate with the word “reporter” on it. At intervals, more or less frequent 
as business waxes and wanes, the reporters converge upon the pedestals 
and hand to one of their number at the telegraph key slips on which they 
have hurriedly penciled the particulars of sales which they have just heard 
made in the crowds about the different posts. Briskly the reports they 
bring in are “pounded out” by the man at the key, and back they dart to 
eavesdrop again. In two rooms on the top floor of the building is to be 
found the next stage in the ticker service. One is occupied by the New 
York Quotation Company, which is controlled by the Stock Exchange, the 
other by the Gold and Stock Quotation Company, a subsidiary of the 
Western Union. The first supplies the reports of the transactions on the 
Floor to the offices of members of the Exchange below Chambers Street; 
the second to all the other tickers in New York and in fifty cities throughout 
the country. 

In each room sit two groups of men, one active, the others in reserve. 
There are five men to a team. One sits before a round disc studded with 
red and white push-buttons lettered and numbered like the keys of a type¬ 
writer. The other four sit around him, each with one ear close to a telegraph 
sounder in its wooden box. The wires to each sounder are the wires com¬ 
ing from one of the four pedestals downstairs. As first one then another 
of the instruments chatters out a metallic message of some sale on the 
Floor, the central operator’s hands with their long, facile fingers spell out 
the message again on the buttons before him. He has taken the message 
“by ear,” as he regularly does in dull times when selling is slow and only 
one sounder speaks at a time. But the listening operator whose instrument 
has spoken also writes the particulars of the sale on a slip of paper and 
sets it before his partner. In quiet times this is only necessary in order 
to help the sending operator in checking his work. On busy days, however, 
it saves him from the impossible task of listening to four instruments at 
once and disentangling their dots and dashes. 

As he spells out each sale on the red and white buttons the ticker on 
the table before him prints on the tape the record US 57! U 145! K 500.20 
Pa 108 BO 200.97 K 20 R i6f U 145! MP 31*. As we watch the record 
grow on the marching tape we know that on just such a tape at precisely 
the same instant in 500 offices precisely the same record is being printed. 
In the next room the same process is sending the same word to probably 
ten thousand offices and banks in fifty cities and towns of the country. 

Like the winking blackboards on the walls downstairs, these rooms, 
with their staccato sounders and the nimble fingers of the operators playing 
on their parti-colored discs, seem symbolic too. They remind us that every 
transaction on the Floor, every purchase, every sale, is known to the 


134 


RISK AND RISK-BEARING 


public hardly more than an instant after it is made. It is little exaggera¬ 
tion to say that a sale of stock is reported all over the city before the brokers 
who take part in it have had time to record it on their pads. The reporter 
hears the offer, catches the word “sold” or sees the gesture which closes the 
transaction, walks twenty feet across the Floor to the nearest pedestal and 
taps out the report on the telegraphic key. Upstairs the operator at the 
disc catches the message “by ear,” spells it out on the buttons, and before 
the buying and selling members have gathered themselves together for the 
next trade the ticker in every broker’s office in the Street has printed the 
fact on the tape. 

In busy times the ticker does fall behind the market, but on an ordinary 
day it is not behind at all. The swiftness of the electric current and the 
rapidity of the trained workers who bridge the gaps in the circuit keep the 
ticker service well abreast in the market. The man who has given an order 
to his broker to buy 500 Steel at 60, if he only stays near a ticker can 
know when the market has reached his price, and his stock presumably been 
bought, much sooner than, if he were buying a dozen eggs, the grocer could 
have them wrapped up for him. 

The Stock Exchange does its business in the open. The public knows 
what has happened there just as quickly as the members on the Floor. 
No trades are concealed; no news of trades delayed; no prices made or 
broken without instant word going to every part of the land. Of course 
this is not to say that the reasons for each sale, the forces behind it, the 
meaning of each movement in price, of each “bulge” or “break,” are trans¬ 
mitted to the public. They are not known even to the members themselves 
except by inference and deduction and guesswork. The Stock Exchange no 
more than any other organization of men can penetrate the individual mind 
and heart and determine infallibly and instantaneously why the individual 
performs a given act. How, then, can it tell the public why a certain thing 
happens and what the happening portends? But it can tell the public 
just what does happen, and it does so with astonishing suddenness. It is 
hard to see how a more complete and instantaneous mechanism for spread¬ 
ing broadcast the news of the course of business in a given field could be 
devised. What the Stock Exchange does the country knows, and knows it 
the next moment. 1 

It may be added that the Exchange’s control of quotations is 
used not merely to enable it to furnish a valuable service to its mem¬ 
bers, but also as a source of considerable revenue and as a means of 
controlling certain activities of individuals not members of the 
Exchange. For though ticker privileges are sold to non-members, the 

1 Adapted by permission from H. Howland, “Gambling Joint or Market 
Place,” Outlook, June 28, 1913, pp. 423-25. 


THE SECURITY MARKETS 


135 


Exchange retains the right to refuse quotation to bucket shops 1 
and others whose use of the quotations is calculated to bring discredit 
on the business of the Exchange. 

The other chief means of securing information for the benefit of 
members and their clients is found in the rules governing the listing 
of securities. The Stock Exchange maintains a committee on stock 
listing, whose business is to receive and consider applications for 
placing securities on the list and make recommendations concerning 
them to the governing committee, or in the case of certain high-grade 
securities, to list them without reference to the governing committee. 
The requirements for listing are extremely strict. The corporation 
applying for the listing of its stock must file a statement showing, in 
addition to the ordinary information concerning its charter, form of 
capitalization, and field of business, complete details concerning its 
financial structure and financial strength. This includes such detailed 
information as: 

A. Voting power of obligations of debt. 

B. (i) Purpose of issue; (2) application of proceeds; (3) amount issued 
for securities, contracts, property; description and disposition; (4) addi¬ 
tional property to be acquired. 

C. Tabulated list of constituent, subsidiary, owned, or controlled 
companies showing (a) date of organization; ( b ) where incorporated; ( c ) 
duration of charter; ( d ) business, and (e) capital stock issues (by classes), 
par value, amount authorized, issued, owned by parent company. 

D. (1) Mortgage, and (2) other indebtedness, (a) date, ( b ) maturity, 
(c) interest rate, ( d ) redemption by sinking fund or otherwise, ( e ) amount 
authorized, and (/) amount issued; (3) similar information regarding 
mortgage and all indebtedness of constituent, subsidiary, owned, or 
controlled companies. 

Other liabilities in detail, description of property owned in fee, con¬ 
trolled, or leased. 

Policy as to depreciation. 

Output or production for the preceding five years, dividends paid, 
income account, balance sheet, and similar accountings for predecessor, 
constituent, subsidiary, owned or controlled companies and corporations 
recently consolidated. 2 

The corporation must also agree not to dispose of its stock interest 
in subsidiaries, except under existing authority or on direct authoriza- 

1 A bucket shop is an organization posing as a commission house which executes 
fictitious trades for customers, paying them their profits or pocketing their losses. 

2 Adapted from Rules of the New York Stock Exchange , reprinted in J. E. 
Meeker, The Work of the Stock Exchange , pp. 577 ff. 


13 6 


RISK AND RISK-BEARING 


tion of stockholders, to publish at least once a year an income account 
and balance sheet, to maintain a transfer and registry office in New 
York City, to notify the Exchange of any change of capitalization, 
to publish promptly any action in respect to interest on bonds, divi¬ 
dends, or allotment of rights, and to have on hand at all times a 
sufficient supply of certificates to meet the demands for transfer. 

These provisions are intended to secure adequate publicity for 
the business of the corporation, and to enable investors to form an 
intelligent estimate in regard to their value. The provisions control¬ 
ling the listing of new securities are much more adequate for this 
purpose than are the provisions controlling corporations whose stocks 
have been listed. Once the securities of a corporation have been 
placed upon the list, the Exchange, as a matter of fact, exercises very 
little supervision over the management of the business, so long as 
investors are notified promptly of the declaration and passing of 
dividends, issuance of rights, suspension of interest payments, and 
similar necessary data. Even the requirement that an annual income 
statement and balance sheet be published is not rigidly enforced, 
though nearly all corporations whose securities are listed do, as a 
matter of fact, publish this information. 

Control of the Exchange is highly centralized .—The Stock Exchange 
is controlled by a Governing Committee of forty members together 
with the president and treasurer of the Exchange. This committee 
has practically absolute power not only to lay down rules for trading 
but to discipline members by fines, suspension, and expulsion. Sub¬ 
ordinate to the Governing Committee are a number of special com¬ 
mittees composed of members of the Governing Committee and 
appointed by it to manage special departments of the work. For 
example, the management of the Stock Exchange Building is in the 
hands of the Committee on Arrangements, and the giving out of 
quotations is controlled by the Committee on Commissions and 
Quotations. 

It has frequently been suggested by outside critics that the Stock 
Exchange should be incorporated in order to bring it under a larger 
degree of governmental control. This suggestion the Exchange has 
steadily resisted. The Exchange authorities deny that the public 
would gain from such incorporation any valuable powers of control 
which it does not already possess. On the other hand, they fear 
that incorporation would tie the hands of the Governing Committee 
in matters of discipline, and make impossible prompt action in closing 


THE SECURITY MARKETS 


137 


the Exchange on occasions of public disturbance, in regulating prices 
of cornered stocks, and in similar cases of emergency. The expe¬ 
rience of the Chicago Board of Trade, which is incorporated, does not 
indicate that incoiporation would be likely to have any important 
effect either for good or for evil. 

The membership of the Exchange includes specialized groups. —As 
was noted above, membership in the New York Stock Exchange is 
limited to 1,100 members. The only way, therefore, that a new mem¬ 
ber can be admitted is through a transfer of the membership of some¬ 
one else. The “seats” are regularly bought and sold, fluctuating in 
value with the volume of speculation. During the war boom, seats 
in the New York Stock Exchange sold as high as $115,000. Purchas¬ 
ing a seat, however, does not of itself entitle one to a membership, as 
the Committee on Memberships scrutinizes every candidate’s qualifica¬ 
tions with great care, and individuals whose record either for reliability 
or for financial strength is unsatisfactory are quite often rejected. 

The membership is made up chiefly of the following classes: (1) 
partners in commission brokerage houses; (2) “two-dollar” brokers; 
(3) “specialists”; (4) dealers in odd lots; (5) professional speculators; 
and (6) inactive members. A survey of the work of these classes of 
members will serve to bring out most of the essential features of the 
organization and work of the Exchange. 

1. The commission brokerage house buys and seUs stocks and bonds 
as the agent of outside investors and speculators. —It is always unincorpo¬ 
rated, sometimes individually owned, more often a partnership. 
A large brokerage concern usually has memberships in all the impor¬ 
tant exchanges. Officers are maintained in leading cities all over 
the country, and private wire connections established between them. 

The chief asset of a commission house is its list of customers. 
Its chief income is the commission it obtains for executing trades, 
either upon the exchange floor or elsewhere. The commission for 
executing trades is 15 cents per share for stock selling from $10 to $125 
per share; 7! cents per share below that figure and 20 cents per share 
above, and $1.50 per $1,000 for bonds. For this commission the broker 
attends to all the details not only of executing the trade but of delivery, 
payment, and transfer on the books of the issuing corporation, and 
also furnishes its customers and the public generally with a large 
amount of service, for which it is not directly paid. Many houses 
maintain customers’ rooms in which quotations are posted on 
blackboards as fast as they are received from the Exchange. Financial 


138 


RISK AND RISK-BEARING 


journals and manuals and other sources of information are kept 
available, and advice is freely given on the customer’s investment or 
speculative problems. In addition to this, the commission brokerage 
house regularly undertakes the responsibility of financing its cus¬ 
tomers’ purchases, exacting a “margin” of from 5 to 40 per cent of 
the amount, and furnishing the rest of the capital itself or borrowing 
it from banks. 

Facilities are also offered for executing what is known as a u short 
sale .”—This is a sale of stock which the customer does not own but 
which is borrowed for him by the broker for delivery, the loan being 
repaid when the stock is bought at a later date. The financing and 
executing of such transactions may be illustrated by the following 
diagram: 



A and D are speculators, and B and C their respective brokers. 
A orders B to “sell short” for him 100 shares of Southern Pacific 
stock, posting about $1,000 as margin. B sells the 100 shares at 
$98 each to C, who represents D, a speculator desirous of purchasing 
100 shares of Southern Pacific. D usually posts with C $1,000 as 
margin. Delivery and payment must be made the next day. In 
order to make delivery, B borrows 100 shares of Southern Pacific 
from F, posting with F the full $9,800 as security, and delivers the stock 
to C, collecting from him $9,800. C then posts the stock with E, a 
bank, as collateral for a loan of say, $8,000, advancing the balance 
out of his own funds. Usually B collects from F interest on the $9,800, 
which is posted with him as collateral for the loan of the 100 shares of 
stock. D pays interest to C on his unpaid balance of $8,800 and C, 
of course, pays interest to E on the $8,000 which he has borrowed. 
Usually C and F pay the call loan rate, while D pays a customary rate 
which does not fluctuate as often as the call loan rate but averages 
somewhat higher. In case a dividend is declared on the stock while 
the short trade is open, both D and F are entitled to receive it. Hence 
A must make good one dividend, the company, of course, paying the 
other. 






THE SECURITY MARKETS 


139 


The advantage of the transaction to F is that he is enabled, through 
loaning his stock, to borrow on it up to 100 per cent of its face value; 
whereas through a bank he could probably not borrow more than 
70 or 80 per cent. A may close out the transaction at any time by 
ordering B to purchase stock in the open market and deliver to F 
in repayment of the loan. D also may close out the trade at any 
time by ordering C to sell the stock in the open market. In case F 
desires the return of his stock before A wishes to purchase, it is B’s 
business to borrow the stock elsewhere. In case the stock cannot be 
borrowed, B must “cover the sale/’ i.e., buy the stock in for A’s 
account. Most brokers will not execute orders for short sales except 
in securities which have a large floating supply, so that the risk of being 
compelled to “cover” in this way is small. In case of a scarcity of 
stock for loaning purposes, the interest rate paid by the lender of 
stock will go below the usual call rate. Sometimes the lender of 
stock is enabled to get the use of the money for nothing, in which case 
the stock is said to loan “flat” and occasionally a premium is paid for 
use of the stock in addition to the waiver of interest. 1 

In practice, of course, C does not negotiate a separate loan at the 
bank for every margin trade his customers may make. What he 
does is to borrow on the mass of securities in his possession as much 
money as he needs to take care of his customer’s demands. Most 
brokers carry their customers on smaller equities than do the banks, 
so that the broker has to advance part of the funds on his own capital. 
Some, however, pursue the opposite policy, requiring margins so large 
that they can secure larger loans from the bank than they make to 
their customers. The purpose of the margins is, of course, to protect 
the brokers against adverse fluctuations in the price of the stock. 
In the illustration above, if, while A is still short, the price of Southern 
Pacific advances, B must have some protection in his obligation to 
return the stock to F on demand. Even if he is not required to return 
the stock he may be called upon to post additional money for F’s 
protection. In case the advance in prices is large, A will be called 
upon to post additional margin, and if he is unable or unwilling to do 
so, the stock will be bought in the open market and delivered to F in 

x For instance, the following quotations were published on April 7, 1921, 
“Crucible, 1-16 per cent premium; American Sugar, B.R.T., D.&H., Maxwell, 
Penna., flat; L.&N., 2; American Smelting, Anaconda, Baldwin, Bethlehem B., 
General Motors new, Alcohol, M.P., Food Products, U.S. Rubber, U.S. Steel, 6; 
Atchison, B.&O. C.P., C.&O., St. Paul, R.E., Erie, Marine common, Marine pre¬ 
ferred, N.H., Central, N.P., Reading, S.P., Studebaker, U.P., 5 per cent.” 


140 


RISK AND RISK-BEARING 


repayment of the loan, and the loss charged to A’s account. In case a 
sudden change of market makes it impossible for the broker to sell 
the stock at a price which protects him, or, in other words, in case the 
loss is greater than the margin A has posted, B has a valid claim 
against A for the additional loss. D’s margin protects C against a 
decline in price just as A’s margin protects B against advance. 

The volume of exchange trading is very great .—The way in which 
such transactions as those described above make possible an enormous 
volume of trade through the rapid turnover of a comparatively small 
amount of stock has been described as follows: 

The process is very simple, once you get it clear. We take a simple 
case. Suppose A has 1,000 shares of Bethlehem Steel. He may be carry¬ 
ing it for a client. Anyhow he has it—the actual stock. Let us suppose 
that he is carrying it for a client, and has hypothecated it along with other 
stocks for a loan at his bank. Now a speculator wishes to sell Bethlehem 
Steel for a fall, that is, to sell it short. He has no stock, but he knows he 
can borrow it. Men-at the Bethlehem Steel post are bidding for it. One 
who shall be C bids 150^ for 1,000 shares, and B cries “Sold!” That goes 
out on the ticker instantly—1,000 shares of Bethlehem Steel sold at 150^ 
and you might suppose that so much actual property had changed hands, 
like real estate. But the seller, remember, had no Bethlehem Steel Stock to 
sell. He may never have owned a share in his life. But all the same he 
must deliver 1,000 shares to C. 

After the close of the day’s trading there is a “loan crowd,” where all 
active stocks are borrowed and loaned. B, the speculator, shouts: “I 
want to borrow a thousand Bethlehem.” And now A appears. He has 
1,000 shares of stock hypothecated at the bank, and he agrees to lend it to 
B. They exchange memoranda. So now A gets his 1,000 shares of Bethle¬ 
hem Steel back from the bank (either by paying the money he has borrowed 
on them there or substituting other collateral in their place), and delivers 
the stock to B in exchange for a certified check of $150,500. B delivers 
this borrowed stock to C, to whom he sold it, and receives from C a check 
of $150,500 in payment for it. 

The actual stock is now in possession of C, who hypothecates it at his 
bank. The next day another speculator, who shall be D, in like manner as 
B, is moved to sell 1,000 shares of Bethlehem Steel stock for a fall. He 
sells it to E, borrows it from C and delivers it to E. Now three people have 
title to 1,000 shares of Bethlehem Steel stock, namely, (1) A who had it 
first and loaned it to B, (2) C who bought it from B, and (3) E who bought 
it from D. Actually only 1,000 shares of real stock have figured in these 
transactions, but 2,000 more have been bought and paid for. This may go 
on and on so long as nothing unexpected happens. 


THE SECURITY MARKETS 


141 

If the price falls the speculators who have sold it short and borrowed 
it for delivery return it to those from whom it was borrowed. If it falls, 
for example, to 140I, B buys 1,000 shares at that price, for $140,500, 
sends the stock to A from whom he borrowed it, and gets back his own 
original $150,500. The difference is his profit. If the price rises, the short 
sellers buy it in the same way and return it to those from whom they 
borrowed it, but they do it in that case at a loss, because the stock they 
buy is worth more than the stock they borrowed. 

The unexpected does sometimes happen. A number of people may have 
been lending the stock over and over to short sellers, intending all at once 
to demand the return of it in a concerted manner. The speculators are 
deceived by the willingness with which the owners lend it and deduce from 
that that the supply is ample. But all at once the lenders call for the return 
of the stock and the borrowers, unless they can find other owners who will 
lend, are compelled to buy the stock in the open market at a loss. 

So corners are contrived. Speculators are beguiled to sell what they 
do not own, because they think it will fall and can be bought cheaper tomor¬ 
row, and the stock with which to make their deliveries is loaned to them 
by manipulators who may know all the time approximately how much real 
stock there is in the floating supply. When the ratio of contracts to actual 
stock is very high they call suddenly upon the borrowers to produce it. 
As it cannot be produced, the borrowers have to settle, that is, they have to 
buy at any price, and their bidding for it causes wild advances in the price. 

In a stock on which speculative interest is centered there is, of course, 
a great deal of mere “trading” by professional members of the Stock 
Exchange who seldom receive or deliver stocks at all. They buy and 
sell the same day, their purchases canceling their sales. One who buys 
1,000 Bethlehem Steel at 10 o’clock and sells 1,000 shares at 3 o’clock is 
“even.” The two transactions pair themselves off at the Clearing House 
afterward. The trader merely sends a record of what he has done to the 
Clearing House. He owes nobody any stock; nobody owes him any stock. 
But there is a difference in money to be settled. He may have bought from 
A 1,000 shares in the morning at 150I, and in the afternoon he may have sold 
1,000 shares to Z at 151^. He has made a profit of $1,000; but he neither 
receives stock from A nor delivers stock to Z. He merely attaches to his 
Clearing House sheet a draft for $1,000. The Clearing House deals with 
A and Z. A has sold 1,000 shares of stock at 150^ for which he will receive 
$150,500 in money. Z has bought 1,000 shares of the same stock at 151^, 
for which he must pay $151,500. The difference is $1,000 and that is the 
trader’s profit. A sold the stock to the trader and Z bought it from the 
trader, but it is Z who receives it from A. The trader was in the middle, 
never intending either to receive or deliver stock. The Clearing House 
sends him $1,000 which is the difference between what A gets and Z pays 


142 


RISK AND RISK-BEARING 


for the i,ooo shares of stock. And by these processes mainly is it possible 
for Stock Exchange “transactions” greatly to exceed the actual amount 
of a given stock existing in Wall Street. 1 

Large brokerage houses maintain an elaborate system of private 
communication between their offices in leading cities. —These are called 
“wire houses.” The following is an excellent description of this 
service: 

A large part of all the stock bought and sold in the Wall Street offices 
of brokerage firms is of course for the account of operators who live in New 
York. But in addition to this the large brokerage concerns have a remark¬ 
ably extensive telegraph system whereby orders are gathered from far distant 
points. The “wire map” of any one of a half-dozen or so of the large houses 
looks like a complete railroad guide of the United States. One particular 
firm reaches by private leased duplex wire from its main Wall Street office 
to such cities as Baltimore, Washington, Charlotte, Charleston, Atlanta, 
Savannah, Augusta, Jacksonville, New Orleans, Memphis, Chicago, Cleve¬ 
land, Cincinnati, Omaha, Colorado Springs, Denver, Salt Lake City, Butte, 
Spokane, San Francisco, Pasadena, Los Angeles, Coronado Beach, and 
San Diego. It also has wire connections to Boston, Portland, Montreal, 
Toronto, Detroit, Gary, Indianapolis, Louisville, St. Louis, Kansas City, 
Milwaukee, St. Paul, and Winnipeg. This particular firm has six branches 
in the state of California alone. These wires may connect with branch 
offices or merely with correspondent firms. 

The relative importance of this outside business may be judged from 
the following figures. On two successive days in the summer of 1919, 
75,000 and 60,000 shares respectively were handled by branch offices; 
while 38,000 and 46,000 shares respectively were handled by the main 
office in New York. The extent of this “outside” participation in New 
York Stock Exchange speculation is, of course, very much increased in 
times of active bull markets, such as prevailed in the early summer and 
again in the autumn of 1919. 2 

2. ll Two-dollar brokers” are exchange members who specialize in 
the execution of trades for other members. —They are so called because 
their commission at the time the name arose was $2 per 100 shares of 
stock bought or sold. (The present figure is $2.50.) These brokers 
are of two classes. Some of them form permanent connections with 
brokerage houses, doing practically all of their floor work. Such a 
connection is especially valuable to a small house whose exchange 

1 Adapted by permission from “The Phenomena of Phantom Stocks/’ New 
York Times Annalist , August 2, 1915, p. 127. 

2 Adapted by permission from H. G. Moulton, The Financial Organization of 
Society , pp. 290-91. (University of Chicago Press, 1921.) 


THE SECURITY MARKETS 


143 


member is the proprietor of the business or a senior partner, and whose 
time is more valuable in the office than it would be on the floor. A 
large house finds it, as a rule, more economical to have a partner who 
does the floor work, but small houses often do not have enough floor 
trading to occupy the entire time of a partner. Other two-dollar 
brokers are employed by the floor members of brokerage houses to 
assist them in rush periods, or at times when they have orders calling 
for immediate attention in different parts of the floor at the same 
time. This is particularly likely to be the case at the opening of the 
market, when the trader’s book is filled with an accumulation of 
overnight orders. 

It may appear that there is an unduly wide spread between the 
commission of $15, which the brokerage house charges its customers 
for buying or selling 100 shares, and the $2.50, which it pays the 
“two-dollar broker” to do the work for it. It must be remembered, 
however, that the two-dollar broker has no responsibility to furnish 
information to customers, maintains no selling organization, keeps no 
books except his list of open orders and his record of work done, 
borrows no money from banks or stocks from other brokers, makes 
no deliveries, and, in general, has no business cares and responsibilities 
after his rather short day’s work is done. On the other hand, the 
accounting work alone of a large brokerage house is a task requiring 
the employment of many clerks and bookkeepers, while the annual 
cost of a private wire between two important trading centers may 
run far into thousands of dollars. Expensive services in furnishing 
information are usually provided. It is these outside services, rather 
than the actual work of making a trade on the floor of an exchange, 
for which the commission house receives its compensation. 

3. The “ specialist ” makes a market for inactive stocks .—The 
specialist is a trader and broker who devotes himself solely to the 
execution of orders and stocks traded in at the same point on the 
floor, sometimes indeed solely to the issues of a single corporation. 
It is the business of the specialist to make a market at any time for 
the security in which he specializes. This he does by quoting a “bid 
and asked” price upon request. If few other dealers are interested 
in the security in which he specializes and there is little speculative 
interest in it, he may be able to keep the market for himself while 
quoting a bid and asked price a considerable distance apart. If so, 
he makes of course a correspondingly large profit by buying at the 
bid and selling at the offered price. If the security becomes more 


144 


RISK AND RISK-BEARING 


active, he has more competition and must quote prices closer together 
in order to make trades, thus reducing a profit on a single transaction 
but presumably increasing the number of his trades. The “ specialist ” 
also acts as a “two-dollar broker,” handling orders for other brokers 
to buy and sell his special stocks. In this case he gets the $2.50 
commission just as the regular two-dollar broker would get it. He is 
of course not allowed to act both as a broker and as a dealer in the 
same transaction, and would be punished by a heavy fine or suspension 
if caught attempting to do so. 

4. The odd lot dealer handles small orders .—Another very interest¬ 
ing branch of stock exchange business, as it is carried on in New York, 
is the work of the odd lot dealer. The standard unit for dealings on 
the New York Stock Exchange is, as previously stated, 100 shares, 
and only trades of that size, or of some multiple of 100 shares, are 
reported on the ticker or closed out through the clearing house. 
There is however a very large volume of business in less than 100 
share lots—some estimates of it run as high as 20 per cent of the total 
trade. Almost any brokerage house will accept orders for as few as 
25 shares for margin accounts and smaller lots for cash sale or purchase, 
and some houses handle as few as 10 shares in a single order on margin 
account. In executing these trades, resort is nearly always had by 
the broker to representatives of a few large houses which specialize 
in the odd lot business. These houses buy and sell on their own 
account, making their income out of profits on the trade, not out of 
commissions. The customer, of course, pays the usual commission, 
but this goes to the house which represents him, not to the odd lot 
house. The most frequent way in which such orders are executed is 
to hold them until the next trade in the round lot market, immediately 
after which the odd lot man will sell at one-eighth or one-quarter 
point 1 above, or buy one-eighth or one-fourth below the price recorded. 
This gives him a profit of one-quarter or one-half point if he is able 
to make both a purchase and a sale before the “round lot” price 
changes. 

Another method which avoids the delay incident to waiting for a 
sale is for the odd lot house to buy at the bid price and sell at the 
offered price (or one-eighth away in the case of inactive stocks). In 
this case the odd lot dealer makes his profit out of the spread between 
the bid and the asked price, just as does the specialist. 

X A “point” is one dollar per share in stock quotations, or ten dollars per 
thousand dollars face value in bond quotations. 


THE SECURITY MARKETS 


145 


In order to make his deliveries, the odd lot man is frequently 
obliged to buy or borrow ioo share lots and split them up into frac¬ 
tional lots, remaining “long” of the unused balance if he buys, or 
“ short ” of the amount sold if he borrows* This leaves him, of course, 
exposed to the risk of market fluctuations, but he is able to keep this 
risk at a minimum by buying part of his stocks and borrowing part 
of them, so that in case of a market change he will make about as 
much on the stocks in the one group as he loses on the stocks in the 
other. 

The following is a description of the work of the odd lot dealer: 

The stocks traded in on the Exchange are divided by the “Odd Lot” 
dealer, into two classes, which are known as “eighth stocks” and “quarter 
stocks.” An “odd lot” order in an “eighth stock” is executed at one-eighth 
point from the next “full lot” sale, or if the client so desires, at the bid or 
offered price. Orders in “quarter stocks” are executed at one quarter 
point from the next full lot sale, or one-eighth point from the bid or offer. 
A large majority of the stocks are “eighth stocks.” The “quarter stocks” 
are either inactive or the price fluctuations in them are at such wide figures 
that trading on so narrow a margin for profit as one-eighth of one percent 
would be impracticable to the odd lot dealer, and would not permit him 
to give the free market in every stock on the list whether active or inactive 
that now exists for the trader in odd lots. 

The firms which deal exclusively in odd lots are represented by as many 
as twenty-five or more members on the New York Stock Exchange. Each 
one of these representatives is located in his particular place or station on 
the Exchange floor and confines his activities solely to the execution of the 
odd lot orders in the group of stocks assigned to him. 

The individual desiring to buy or sell an odd lot gives an order at the 
office of a Stock Exchange house or to one of its branch offices or out-of-town 
correspondents with whom he has an account or wishes to open one. The 
New York Office immediately upon receipt telephones the order to its clerk 
on the floor of the Stock Exchange who writes it on an order slip and hands 
it to a Stock Exchange employee in charge of the pneumatic tubes at his 
booth. It is then sent through a tube to the tube station at the post at 
which the particular stock is traded in, where it is removed from the carrier 
by another Stock Exchange employee and by him handed to the odd lot 
dealer or placed on the odd lot dealer’s special clip at his post. If it is a 
limited order, the odd lot dealer enters it in his book; if it is a market 
order he executes it, basing the price on the first sale of a full lot that takes 
place after he receives the order. He then hands the report of the execution 
of the order to the tube employee who sends it through another tube back 
to the original tube station; here it is handed to the telephone clerk who 
telephones it to the office. 


146 


RISK AND RISK-BEARING 


Market orders: An odd lot market order is an order to buy or sell a 
stated number of shares from 1 to 99 at | (or £) away from the price of the 
next sale of a full lot taking place after receipt of the order by the odd lot 
dealer. Market orders received before the opening of the market are 
executed at | (or |) from the opening price. It sometimes happens, how¬ 
ever, especially when important news about a stock has come out over night 
that there will be a wide, or as it is sometimes called “a split opening,” 
when sales at different parts of the crowd occur simultaneously at different 
prices. For example: U.S Steel might have an excited opening, sales of 
ten thousand shares taking place immediately upon the ringing of the open¬ 
ing gong at from 80 to 81 and the ticker would report “U.S. Steel 10,000, 
80 to 81.” A reasonable opening price between these prices would have to 
be decided on. In this case it would very likely be that the odd lot dealer 
would buy at 8of or sell at 8of. 

Limited orders: An odd lot limited order is an order to buy or sell a 
stated number of shares from 1 to 99 at a stated price. For example: An 
order is given “Buy 10 Reading at 69.” That this order may be executed 
Reading must sell at 68f or less. If the first sale after receipt of this limited 
order permits of its execution, the limit is ignored and the order considered 
a market order. Should the first sale be 68| the order would be executed 
at 68f. A limit is also ignored on a limited order if the opening sale any 
morning permits of its execution while the order is in force. A limited order 
must be executed at its limit, however, when the next sale after it is received 
does not permit of its execution. For example: An order is given to “Buy 
10 Reading at 69.” If the first sale after receipt of the order is 69^ and the 
next sale 68§ the order is executed at 69. In this case the odd lot trader 
secures exactly the price he would have secured had this order been for 
100 shares, because his broker would have been bidding 69 and the 100 
shares would have been sold to him at 69 on his bid before the stock could 
sell at 68|. 

Stop orders: A stop order is an order to buy or sell a stated number of 
shares at the market after a fixed price is reached. An odd lot stop order 
is executed at | (or £) from the first sale of a full lot which makes the stop 
order operative. For example “Sell 10 Reading 69 Stop” If Reading 
sells at 69! and then at 69 the order is executed at 68| but if the sale after 
69^ is 68^ then the stop order is executed at 68|. 

Orders to buy or sell at the close: An order may be given to buy or sell 
an odd lot “at the close.” The execution of these orders is always based 
on the closing bid and offer and not on the last sale of the day. It would 
be impracticable for the odd lot dealer to trade on the last sale, as the last 
sale might occur as early as 2130 p . m . and this sale, for example, might have 
been at 69 and the close 68-68^ or 69^-70. In justice to all concerned 
therefore an order reading “At the close” must mean, at the closing bid 
or offer (or § away). 


THE SECURITY MARKETS 


147 


These methods for conducting trading in Odd Lots, have been in general 
use on the New York Stock Exchange for the past forty years. 1 

5. Floor traders speculate on their own account. —Professional 
speculators are not always members of the Exchange, but many of 
them do find it advantageous to purchase memberships either in 
order to make their own trades on the floor of the Exchange or in 
order to secure the advantage of the lower rate of commission which 
is charged by members executing trades for one another. Those who 
trade for themselves are usually what are known as “scalpers,” i.e., 
speculators who trade for small profits—an eighth to a half “point” 
on a trade, and close out their trades quickly if the price goes against 
them. In this sort of speculation, of course, the trader is governed 
not by considerations of the investment value of the securities in 
which he trades but by his judgment of the conditions which affect 
the market of the immediate future. Consideration will be given 
to these “technical conditions,” as they are called, in chapter ix. 

6. Inactive members are numerous. —These comprise the office 
members of certain brokerage houses, who seldom appear on the 
floor, a few large professional operators who own memberships for 
the sake of the reduction in commissions which it gives them, and a 
great many representatives of prominent investment institutions, 
who make little direct use of their memberships but desire to have 
some voice in the management of the exchange or find some advertis¬ 
ing value in their connection with it. 

The “Curb” Market specializes in newer stocks. —Other exchanges 
in the United States need little description, as they are all much smaller 
than the New York Stock Exchange, and present no points of differ¬ 
ence which are of interest. Until recently a noteworthy exception 
to this statement was found in the New York Curb Market, the great 
market place for unlisted securities. This was an informal gathering 
of brokers who met in the open air on Broad Street, in New York 
City, and carried on an active trade, largely in mining stocks and the 
stocks of new corporations. Orders were transmitted by signals from 
adjacent windows, and quotations were recorded only by newspaper 
reporters who collected them from various brokerage houses specializ¬ 
ing in the Curb trade. 

At first the Curb trade was entirely disorganized, anyone being 
free to trade or refuse to trade with anyone he pleased. An organiza- 

1 Adapted by permission from a pamphlet issued by Carlisle, Mellick, and Com¬ 
pany, New York. 


148 


RISK AND RISK-BEARING 


tion was formed however for the purpose of introducing some system 
and responsibility. This organization grew more and more powerful 
till in 1921 it emerged as a full-grown stock exchange, housed in a 
splendid building, with ticker service, listing rules, and with the 
opportunity of trading on the floor restricted to members. A small 
remnant of the old group remained in Broad Street as the “ outside 
Curb,” but this market is at present of slight importance. 

The “inside” or regular Curb is made up chiefly of partners of 
members of New York Stock Exchange firms and constitutes an 
important feature of our market machinery. In theory its listing 
requirements are quite as rigid as those of the New York Stock 
Exchange, but the regulations apparently are not enforced in the same 
spirit, as a considerable trade is reported in securities of corporations 
which refuse to publish income statements or other information deemed 
essential by the older organization. Indeed it is difficult to see the 
advantage of maintaining the two organizations were it not for this 
sort of specialization in the class of securities traded in. The Curb 
serves as a seasoning place where a market can be maintained by 
stock exchange members without even the qualified indorsement 
of the securities which is implied in listing them on the larger 
Exchange. 

The Consolidated Stock Exchange is a rival New York organization .— 
It deals chiefly in the same securities that are traded on the New York 
Exchange. It has an entirely separate membership, consisting chiefly, 
though not entirely, of smaller commission houses and private floor 
traders. The unit of trading is ten shares, and a much larger propor¬ 
tion of the trade is professional “scalping” than is the case in the 
“Big Exchange.” For the most part the prices tend to follow the 
quotations on the New York Exchange. During the past year (1921- 
22) the Consolidated Stock Exchange has suffered a considerable loss 
of reputation on account of a number of failures in its membership. 
It does not appear, however that there is any inherent weakness in 
the organization which accounts for the higher percentage of failures 
among the Consolidated as compared with the New York Stock 
Exchange membership. 

Other American stock exchanges are much smaller than the New 
York Exchange. —The American stock exchanges outside New York 
City are chiefly of local importance. In most of them the securities 
of local public utilities and industrials are apt to be absorbed by the 


THE SECURITY MARKETS 


149 


New York Stock Exchange as soon as they become of national 
interest . 1 

There is also a considerable amount of specialization by industries, 
which is only partly accounted for by location. Thus, the Boston 
Exchange is the great market for copper stocks, though a dozen of 
the leaders are active in New York; automobile stocks are heavily 
traded in Detroit; gold-mining stocks in San Francisco and Denver; 
and public utilities in Philadelphia. 

In general, the methods used in the smaller exchanges are less 
formal, and the requirements both for membership and for listing 
securities less exacting than is the case in the New York Stock 
Exchange. The relative importance of the outside exchanges and 
the New York Exchange may be judged from the fact that the New 
York Exchange has sometimes handled more stock in a single day 
than the Chicago Exchange handled in the entire year. 

There is a large trade in securities outside the exchanges .—Many 
stocks of well-known corporations are not listed on any exchange, 
and many stocks which are listed rarely appear in the published 
quotation lists, for the reason that no trades are executed in them. 
This indicates a lack of public interest in the security, but does not 
prove anything with regard to its merits. Often the inactivity is 
due to the fact that nearly all the issue is closely held by interests 
affiliated with the management, or by investors who are not active 
speculators and cannot be induced to dispose of their holdings except 
by bidding up the price to an unreasonable level. On the other hand, 
the lack of interest may be due to the fact that the corporation in 
question has been so thoroughly discredited that no one cares to buy 
its stock. Again, it may be because the corporation has done no 
public financing, and no broker has ever taken the trouble to work 
up an interest in its securities, so that few people’s attention is called 
to their investment or speculative possibilities. 

Whenever a stock or bond becomes inactive, the bid and asked 
prices draw apart, so that it becomes difficult to buy without running 
up the price and equally difficult to sell without breaking it. In 
such cases the exchange method of dealing is not advantageous. 
Exchange trading really is based on the presumption that, whatever 

1 This is apparently less likely to happen in the case pf public utilities. Peoples 
Gas of Chicago, Pacific Gas and Electric of San Francisco, and Columbia Gas and 
Electric of Cincinnati are the only outside local utilities which are at all active in 
the New York market. 


RISK AND RISK-BEARING 


150 

the price may be, a slight decline will bring in new buying from 
brokers who are present and immediately aware of the change, and 
that a slight rise will bring forth selling. Its foundation principle is 
continuity. If only one or two brokers are interested in a security 
at any reasonable price, it is obvious that public bids and offers on 
the exchange do not constitute an efficient method of establishing 
sales at a price corresponding to the known facts about the security. 
Some device is needed for hunting up a second party to accept a 
given bid or offer. In such cases the most important marketing 
agency is the so called “over-the-counter” market . 1 

Over-the-counter trading means chiefly trading by telephone and 
telegraph. Houses handling this kind of business usually cater more 
to the investment than to the speculative trade, and for this reason 
bonds are handled more than stocks. 

The trader’s equipment consists of a set of telephones in the quiet¬ 
est room available, some financial manuals, a card index of securities 
showing the latest bids and offers, a battery of clerical assistants, a 
quick wit, and a reputation for fair dealing. When the house receives 
an order for a bond or share of stock which it does not itself have for 
sale, inquiries are put out. Sometimes a certain house is known to 
specialize in securities of the particular corporation in question. If 
the security was originally underwritten, the house of first purchase 
will usually “maintain the market” by standing ready to buy or sell 
at a narrow spread of bid and offered price, and will have on file lists 
of present holders who are the most likely prospects for either sales 
or purchases. A house may specialize in the securities of a corpora¬ 
tion for which it has done no underwriting, however, particularly if 
it handles the securities of affiliated interests. If no house is known 
to specialize in the securities of the particular corporation, it is often 
possible for the trader to make a deal through a house which specializes 
in the securities of the whole industry in question . 2 Again, as noted 
above, trade in certain classes of stocks and bonds is centralized in 
certain cities, and an order for such securities will most likely be 
telegraphed at once to some house in that city. In the absence of a 
specialized center, inquiries will be scattered more or less broadcast, 
and, in case of an order of large size, rapidly find their way around the 
United States, Canada, and Europe, each trader passing on the inquiry 

1 In Chicago the over-the-counter market is called the “curb.” 

2 See for examples the advertising columns of the Wall Street Journal and of 
the New York Times Annalist. 



THE SECURITY MARKETS 


151 

to someone else. The inquiry sometimes comes back to the original 
inquirer from various directions. This wandering and redoubling 
may give the appearance of a much more active interest than really 
exists. Sometimes resort is had to advertising, a few houses regularly 
publishing lists of securities which they desire to buy or sell, sometimes 
with, and sometimes without, quotations. In the case of an inactive 
security, it is not unusual for a considerable difference to appear in 
simultaneous bids and offers published by competing houses. 

Independent brokers also make a business of making the rounds 
of the larger houses in New York, getting lists of securities wanted, and 
bringing the trader in touch with others who can supply his needs. 
Some of these brokers take one side of the trade themselves, and may 
make a considerable margin by buying in one office at the offering 
price and selling in another at the bid price. To an increasing extent, 
however, the business is done by regularly organized “street broker¬ 
age” houses, which charge commissions for bringing buyers and 
sellers together. It is of course illegal to take both a commission 
and a profit on the same trade. 

To a large extent the brokerage work of a large investment house 
is done for no commission or a nominal one, to retain the good will of 
customers with whom new issues may be placed. Often, indeed, 
the placing of a new issue requires that assistance be given the customer 
to get rid of his present holdings in order to invest the proceeds in the 
new issue. The underwriter’s profit pn the new issues makes it worth 
while to do a great deal of this brokerage work as an accommodation 
for customers, in order to keep the market for new securities alive. 

H. THE MARKET EOR NEW SECURITIES 

The marketing of new issues of corporation bonds and stocks is a 
business of entirely different character from the business of bringing 
together buyers and sellers of securities already outstanding. In the 
latter case, no one is greatly concerned in facilitating the trade except 
two investors, one seeking to buy and the other to sell. If the issuing 
corporation has any interest in the trade it is indirect, as the quotations 
for its securities may affect its credit at the banks, or influence the 
market for other securities it may have to offer in the future. Conse¬ 
quently, the compensation of the broker or other middleman dealing 
in old securities must come in one way or another out of the difference 
between the prices at which one investor is willing to sell and another 
is willing to buy at the same time. This margin, in the case of securi- 


152 


RISK AND RISK-BEARING 


ties of established merit, is usually rather narrow, so that the middle¬ 
man cannot afford to go into the market and use the arts of salesman¬ 
ship to drum up purchasers. His function approaches that of a real 
middleman , that is, a connecting link between two individuals who 
have a real interest in getting in touch with one another. 

On the other hand, corporations in need of capital are willing, or 
can be forced, to pay for capital amounts largely in excess of what the 
average investor can secure for his relatively small units of capital 
without the aid of the middleman. The margin between the most the 
public will pay and the least the corporation can afford to take, rather 
than fail to market its securities, is a large one, hence the compensa¬ 
tion of the banker who effects the sale can be made much larger than 
is possible in brokerage in old securities. Moreover, new securities 
usually require some active effort to interest investors in their merits, 
in part because they lack the reputation which comes from a satis¬ 
factory record of interest or dividend payments, and in part simply 
because they are unfamiliar and if not advertised would be likely to 
remain unnoticed. This makes the services of specialized selling 
agents necessary. 

The selling of new securities comprises several quite different kinds 
of marketing. —High-grade securities are seldom sold without pro¬ 
fessional aid, except where stock is sold through the issuance of 
“rights” to subscribe at a low price to holders of stock already out¬ 
standing, and even in this case the guaranty of a financial institu¬ 
tion is sometimes secured before the issue is offered. Low-grade 
securities, on the other hand, are frequently marketed direct by the 
issuers, less often through the agency of a bank, broker, or bond-dealer . 1 

The chief institution concerned in the marketing of new securities 
of a conservative type is the investment bank, commonly known as 
the bond house. Typically, this is a highly specialized institution, 
though of recent years a great deal of the business has been taken over 
by bond departments of large city banks, and there is also some 
tendency to combine the business with brokerage in miscellaneous 
stocks. 

1 By high-grade securities are meant the prior lien bond of solvent corporations 
with a fair earning record extending over a period of some years and not engaged 
in a highly speculative line of business, the junior bonds and preferred stocks of the 
stronger members of this group, and the common stocks of a few of the very 
strongest. It should not be overlooked that this classification has reference only 
to new securities. Old securities present such a regular gradation of degrees of 
risk from the safest to the most speculative that a classification into “high grade” 
and “low grade” has little or no usefulness. 


THE SECURITY MARKETS 


153 


Investment houses are of three principal types: first, the large 
houses which deal directly with corporations, taking over whole 
issues or arranging syndicates to divide the responsibility; second, 
the distributing houses, which do little or no large purchasing but 
accept allotments from houses of first purchase and distribute them 
to their customers; third, houses organized in affiliation with indi¬ 
vidual corporations (usually in the public utility field) to aid in the 
distribution of their securities . 1 

Analysis of the merits of a proposed issue of corporation securities 
and determination of the price at which it should be offered to the 
public, if it is deemed to be worth floating at all, is highly expert 
work. It includes an analysis of the corporation’s record of earnings 
and of its balance sheet, an appraisal of the property, usually by a 
firm of engineers, an audit of the books by an independent firm of 
public accountants, a survey of the state of the industry in which the 
firm is engaged, and a study of the outlook for the security market. 
This work, however, has to be done only by the house of first purchase. 
The distributing houses content themselves, as a rule, with the results 
of the investigation made by the purchasing house and apply for as 
many bonds as they think they can dispose of, or, perhaps more often, 
accept the quota which is allotted them. The retail price is fixed by 
the original purchasers, or by the management of the syndicate if it 
is a joint undertaking, and no house is allowed to sell its quota below 
this figure. The weaker distributing houses are dependent on the 
good will of the larger houses to secure their quotas, and can hardly 
refuse to'accept the responsibility for the share which is given them . 2 

The houses which distribute securities direct to investors number 
several thousand in the United States alone. The process of distribut¬ 
ing an issue has been described by one writer as follows: 

When an issue of securities is ready for distribution, it is necessary to 
attract the attention of potential investors. This is customarily done by 

1 For example, the Utilities Securities Corporation’s chief business is the mak¬ 
ing and finding of a market for the securities of a group of midwestern public utili¬ 
ties controlled by Samuel Insull; the Electric Bond and Share Company distributes 
securities of corporations affiliated with the General Electric Company; Henry A. 
Doherty and Company distributes the numerous issues of the Cities Service Com¬ 
pany and its subsidiaries. 

2 Cases are not unknown where distributing houses have accepted quotas of 
undesirable issues rather than risk the loss of good will of the house responsible for 
the securities’ distribution, but insisted on the listing of the securities on a stock 
exchange so they might have a chance to get rid of their quotas through an imper¬ 
sonal market and not have to load up their own customers with them. 


\ 


154 RISK AND RISK-BEARING 

means of a public announcement, which formally calls attention to the 
amount of the issue, the terms, and the date by which subscriptions must 
be in. In many cases a great deal of general advertising has been quietly 
done before the public announcement is made; indeed, the securities may 
all have been subscribed for in advance, in which case the public announce¬ 
ment might be regarded as superfluous, except that it affords an opportunity 
to call attention to the significant fact that the bonds have already been 
disposed of, thereby adding to the prestige of the house or syndicate. The 
public announcement is aimed at investors en masse , and it is effective in 
proportion to the attractiveness of the particular issue and the condition of 
the investment market. 

The subscribers include, as already noted, the houses which have 
participated in the syndicate, other bond houses, dealers and brokers, and 
a number of closely associated financial institutions. One writer has listed 
the following among these associated institutions: 

“ 1. An insurance company and its directors, who, if rich men, will 
probably buy for their own account some portion of a bond issue that their 
company has taken. 

“2. A firm of bankers or a bank in a smaller city that supplies a local 
investment demand. 

“3. A European group or syndicate that acts as a secondary distributor 
or buys securities against which it issues its own debentures, as in the case 
of the Scotch trust companies and the investment associations of Holland. 

“4. Individual trustees or lawyers charged with the investment of 
large estates, w r ho are generally willing to anticipate their requirements if 
anything especially choice is for sale. 

“5. Trust companies and their correlated banks, whose purchases may 
be either for the trust funds of the former or an investment for the deposits 
of both. 

“6. Savings banks, which, taken as a class, are the largest institutional 
buyers of the classes of bonds to which they are restricted by the law r s of 
the various states. 

“7. The list of the various subsidiary groups among which the distribu¬ 
tor of bonds finds his best market might be extended almost indefinitely, but 
those described will give a reasonably clear idea of what may be called the 
headwaters of the investment stream that must be kept continually flowing 
into the bond market.” 1 

The second part of the selling program is the more difficult—that of 
convincing individual investors by direct and personal appeal of the sound¬ 
ness and attractiveness of the issue in question. If the bond market is 
apathetic or crowded with issues—if, as the phrase goes, there are many 
undigested securities floating around—the selling of the entire issue may 

1 Theodore H. Price, Outlook , CVI (1913), 598. 


THE SECURITY MARKETS 


r 55 


prove a very difficult and long-drawn-out affair. It involves the use of 
advertising literature sent through the mails, and to an ever-increasing 
extent it requires expert salesmanship. In former days when the issues of 
securities were few and when the announcement of a new offering was always 
an event of importance, advertising literature made an effective appeal; 
but under present conditions, with a large number of bond houses and with 
thousands of different issues, the mails are to some extent losing their 
effectiveness. Much of this advertising literature is consigned to the waste- 
paper basket by the busy man of affairs without so much as a glance at 
the offer. Personal appeal through salesmen is increasingly necessary to 
bring results. 1 

11 Low-grade” securities are usually marketed by the issuers .—The 
organization for selling bonds and stocks, which has just been de¬ 
scribed, is only available for the service of concerns which have a fairly 
well-established reputation, a strong record of earnings, or in the 
absence of these a very unusual prospect for the future. An invest¬ 
ment banker can only do business profitably by making repeated 
sales to the same buyers. Hence, his good will is his most valuable 
asset, and he cannot jeopardize it by undertaking to float speculative 
securities, even in cases where the prospect of success is such as to 
make the speculation a very attractive one. The reputation of an 
investment banker is injured by a few flotations which result in loss 
to investors more than it is helped by numerous cases where the ven¬ 
ture turns out better than was anticipated. Hence, the rule of “ safety 
first” has come to be accepted as axiomatic in investment banking 
quite as much as in commercial banking. The not infrequent cases 
where securities floated through the stronger investment houses do 
turn out badly are to be accounted for rather by errors in judgment 
than by any disposition to take speculative chances. 

The result of this situation is that concerns which, on account of 
their youth or the hazardous character of the business in which 
they are engaged, cannot meet the standards of the investment bank, 
find it much more difficult to supply their capital needs. Securities 
of these concerns are lumped together in financial literature under the 
caption of “ low-grade securities.” The term is somewhat unfortu¬ 
nate, as it carries with it the implication that all securities outside 
the “high-grade” class are inferior in merit. The class does include 
many securities which are issued in defiance of the dictates of sound 
judgment, and some which are downright fraudulent, but it also 

1 Adapted by permission from H. G. Moulton, The Financial Organization of 
Society , pp. 234, 237-39. (University of Chicago Press, 1921.) 


RISK AND RISK-BEARING 


156 

includes many excellent speculative and semispeculative opportunities, 
and also many thoroughly sound issues which are too small to receive 
attention from an underwriting house. 

New stocks and bonds, which cannot find a market through the 
investment banker are usually sold by the issuing corporation, some¬ 
times by newspaper advertising, sometimes by circularizing selected 
lists of names, sometimes by contracts with concerns which are organ¬ 
ized to sell low-grade securities at exorbitant commission rates. The 
methods used in the marketing of highly speculative securities are as 
a rule very different from those employed by the conservative invest¬ 
ment banker. Flamboyant advertising, exaggerated statements, com¬ 
parisons with successful enterprises of more or less similar character, 
and other methods of inducing people to take snap judgment, have 
been used so frequently both by promoters of fraudulent schemes, and 
by sincere but mistaken promoters, that the whole business of selling 
by direct solicitation has fallen somewhat into disrepute, and perfectly 
legitimate enterprises are frequently handicapped in getting capital for 
this reason. The difficulty is that direct solicitation either by advertis¬ 
ing or by correspondence with miscellaneous individuals whose names 
fall into the possession of promoters, is so expensive that any enterprise 
financed in this way starts out heavily handicapped. If, as is not 
infrequently the case, 50 per cent of every investor’s money goes to 
pay the expense of discovering him and selling him a security, the 
enterprise must earn 20 per cent on the capital actually used, in order 
to pay 10 per cent on the capital raised. Hence, only propositions 
which have some chance of making abnormally high profits are worth 
financing in this way, and enterprises which have a chance of making 
abnormally high profits nearly always involve a correspondingly high 
degree of risk. 


CHAPTER IX 


STOCK SPECULATION AS BUSINESS 

ENTERPRISE 

With this much information concerning the market machinery 
for trading in securities, we are now ready to examine the methods by 
which investors and speculators make use of these markets. In the 
present chapter, we are concerned with the business of speculation, 
that is, trading in stocks and bonds, chiefly stocks, for the sake of profit 
from price fluctuations. Two tasks, therefore, present themselves, 
first, a survey of certain technical practices which are associated with 
speculative trading, and second, a consideration of the methods used 
in attempting to forecast the course of the market as a basis for such 
operations. 

Orders may be placed for execution in either of three ways: at the 
market , at a limit , or on stop-loss order. —A market order is simply an 
order to buy or sell a definite number of shares of stock (or a certain 
quantity of bonds) at the best price obtainable. In the case of an 
active security, it may be assumed that a market order will be executed 
at a price not far from the last quotation, but in the case of an inactive 
security a “market” order of any considerable size may have to be 
executed at a price far above the last price, if a purchase, or far below 
it, if a sale. Market orders have the advantage of certainty of execu¬ 
tion, but are too dangerous to find extensive use outside the list of 
securities in which there is a brisk speculative market. 

A limited order is an order to buy or sell at a certain price, or 
better. In the case of an order to buy, for instance, at 70, if the order 
can be filled at 69 the customer is entitled to secure the stock at that 
price, just as though the order had been placed “at the market.” 
A buying order with a limit above the current price is in effect a market 
order, with a protective provision to secure the buyer against the risk 
that his order may happen to find the market bare of offerings and 
cause an unexpected advance. A buying order with a limit below 
the current price, on the other hand, can only be executed in the event 
of a decline. Such an order is known as a resting order. Sometimes 
it is limited in force to the day on which placed, or to a specified 
period; sometimes it is of indefinite duration. Orders of the latter 


i57 


RISK AND RISK-BEARING 


158 

class may be carried on the books of the broker for weeks before an 
opportunity presents itself for their execution. A scale order is a 
series of resting orders for execution at specified prices, below the 
market in the case of buying orders, above in the case of selling orders. 

A stop-loss order is in a way the reverse of a resting order to buy 
or sell. An order to buy on stop, for instance, is an order to buy 
“at the market” as soon as a trade is made at a certain price above the 
present market. Such orders are used for several purposes. Their 
most frequent pupose is to protect speculators from excessive losses on 
single transactions. If, for instance, A buys stock at 60, putting up 
a margin of ten “points,” a stop-loss selling order at 57 would insure 
that his stock would be sold as soon as the market declined to that 
point, thus reducing the risk of a greater loss. It should be noted 
however that the stop-loss order does not furnish a guaranty that the 
loss will not exceed that contemplated, for after a sale is made at 57 
there may be no bid for more stock above, say 55, and, the broker 
must sell for whatever he can get. As a matter of fact, every margin 
transaction involves a real stop-loss order, for the broker will have to 
sell to protect himself before the margin is exhausted; what the stop- 
loss order does is to place the selling point closer to the market, thus 
increasing the probability that the account will be sold out, but 
decreasing the probable loss from such action. 

Occasionally stop-loss orders are used when there are no open 
trades to be protected, on the theory that if the market advances to 
a certain point it will advance further. For instance, in an active 
market a trader reaches the conclusion that if the quotation for a 
certain security reaches a round number, say 100 (or perhaps reaches 
the highest point it has previously reached during the year), a number 
of buying stop-loss orders from short sellers will be uncovered, and 
a further advance will result. He will therefore place a stop-loss order 
at 100 with a limit of 100J, and a resting order to sell at 100J, hoping 
to shave a profit out of the flurry that will occur if 100 is reached. 1 

A third use of the stop-loss order is connected with the operation 
known as pyramiding , which is the practice of using accumulated 
profits as margin to protect further trades. Suppose B sells short 
100 shares of Baldwin Locomotive at 125, placing with his broker 
$1,500 as margin. In the course of a few days, Baldwin declines to 
120. The trader now has twenty points’ protection, while his broker 

1 All operations aiming at small profits from quick fluctuations are popularly- 
known as “scalping” operations. 


I 


STOCK SPECULATION AS BUSINESS ENTERPRISE 159 

requires only fifteen. The extra $500 is sufficient to enable him to 
sell short an additional 25 shares and have sixteen points’ protec¬ 
tion on the whole “line” of 125 shares. He does so, and the market 
continues to decline till a price of 115 is reached. The profit from this 
further decline is $625, enough to margin 35 or 40 shares additional. 
It is obvious that so long as the market continues to move in a down¬ 
ward direction the size of the order and the rate of profit can be made 
by this method to increase in geometrical ratio, and if no mistakes are 
made concerning the course of prices an enormous profit can be made 
with very small initial capital. A stop-loss order is not essential to 
such an operation, but is frequently used both to control the pyramid¬ 
ing process and to protect the profits. For instance, in the illustration 
given, when the market reached 117 the trader might put in a stop- 
loss order to sell 40 shares at 115, and another to buy 125 at ii8J. 
The selling order-would provide for the further development of the 
pyramid, in case prices continued downward, while the buying order 
would probably close out the trade at some profit, in case of a reversal 
of the trend. 

The stop-loss order for protection is an utterly illogical device and 
its persistent use is one of the surest roads to financial ruin. What it 
amounts to is saying that a certain security, which we do not care to 
buy at the present price, we intend to purchase when it has advanced 
to a figure from one to five points higher. If a security is not an 
attractive purchase at a given level, it is never rendered more attractive 
by an advance, whether of small or large proportions, in its price. 
It is true that in certain situations the stop-loss order is a useful 
protection, but the careful trader does not put himself in such situa¬ 
tions. Invariably the necessity for the use of the stop order goes 
back to one fundamental reason, overtrading. If one’s trades are 
so large in proportion to his capital that an adverse fluctuation of a 
few points forces him to close out or reduce his line, the trades are 
too large. Trades made on account of exhaustion of margin, or on 
account of fear of that contingency, are practically always contrary 
to the trader’s judgment, and man rarely profits by putting himself 
in a position where his action is dictated by fear instead of by judg¬ 
ment. Stop-loss trades are fear trades. 

The only case where an exception to this condemnation need be 
made is in the case of the use of the stop order to develop a pyramid, 
and even here its use is generally an indication of overtrading. If, 
however, our trader, in the illustration cited above, had “inside 


i6o 


RISK AND RISK-BEARING 


information,” or for any reason was practically certain that Baldwin 
Locomotive was about to decline in price to a certain point, and felt 
sure also that there would be no large fluctuations upward before the 
decline was completed, the use of the stop-loss order to build a pyramid 
downward offered him the chance of making the maximum profit out 
of his limited capital. Such situations are very rare; in most cases 
even though the trader were right in his opinion of the trend of the 
market, the use of the pyramid would insure that a strong rally would 
“wipe him out” before the operation was completed. 

Before turning to the technique of forecasting market movements, 
attention must be given also to certain maxims by which speculators 
sometimes attempt to determine a profitable line of individual action. 
“Cut your losses and let your profits run,” is a very common adage 
of the financial district, for which there is very little basis in sound 
i reason. If the maxim means anything definite, it must mean that 
the same price is a desirable price at which to sell if one bought a 
little above it, and an undesirable one at which to sell if one bought 
a great deal lower. “No one ever lost any money by taking his 
profits,” say other sages of the market. Even fairly high-grade invest¬ 
ment houses and financial journals sometimes advise clients to sell 
if they have a profit, but to hold on if they have a loss. This is just 
the reverse of the other maxim, and is equally irrational. The fact is 
of course that the price at which a security was bought is totally 
irrelevant to the question whether it should be sold. If the chances 
seem to favor an advance, and no more profitable use of funds is in 
sight, presumably securities should be held; if they are expected to 
decline, it is irrational to hold on simply because selling involves taking 
a loss, or because it does not. 

“Averaging down” is another fallacious method of speculating, 
very similar in principle to those just discussed. If, for instance, 
C has bought fifty shares of stock at 90 and the price later declines 
to 80, he buys fifty additional shares at that price in order to reduce 
his average cost to 85 and improve his chances of getting out without 
a loss. Of course, the second trade may be a good one, but in decid¬ 
ing whether it is so or not, the price at which the first lot was bought 
is of no significance. 

Holding stock merely because it was bought at a higher price 
instead of selling out when one foresees a decline, and selling to “ take 
profits” in spite of indications that the market is going higher, are 


STOCK SPECULATION AS BUSINESS ENTERPRISE 161 

expressions of the same fallacy, the notion that the past history of 
one’s own individual account has a different significance in determin¬ 
ing the line of one’s future conduct from the significance it has in the 
determination of anyone else’s. Every decision to enter on a new 
speculation, or stick with an old one, should rest on a judgment of 
the future; the past is of no significance except as an index of the 
future, and, except as a part of the whole history of the market, 
one’s own particular record of losses or gains is totally irrelevant. 

The exception to this generalization is the same that was suggested 
in connection with the stop-loss order, that is, the case of the man 
who overreaches himself by trying to handle trades in excess of what 
his capital justifies. The man who overtrades must cut his losses 
short to avoid the embarrassment of margin calls, but by putting 
himself in such a straitened position he has forfeited the privilege of 
following his best judgment. 

Let us turn now to the consideration of the methods used by 
speculators in attempting to forecast the major and minor swings of 
prices. Attempts to make money out of purchase or sale of securities 
may be classified as follows: (a) speculative trading in securities, 
aiming at quick profits; ( b ) speculative trading aiming at long-swing 
profits; ( c ) investment operations aiming at high yield on investment; 
(< d) investment operations aiming primarily at safety. 

Trading in stocks for quick profits comprises the bulk of what is 
commonly known as stock speculation. —The methods of analysis and 
operations used by persons engaged in this kind of speculation may 
be outlined as follows: (a) trading on the technical position; ( b ) 
trading on the news; (c) trading on “inside information,” “tips,” 
etc.; (d) manipulation. 

By the technical position is meant the sum total of conditions 
affecting the movement of prices which have their origin in the opera¬ 
tions of the traders themselves. Scientific study of the technical 
position is usually equivalent to a study of the factors which determine 
the movement of prices in the immediate future, as distinguished from 
those which determine the trend over a period of weeks or months. 
That this distinction is an important one may be seen from the fact 
that in a strong advancing market extending over several months, 
the prices of active stocks will decline on 30 or 40 per cent of the trading 
days. The main elements which constitute the technical position are: 

1. The present and prospective state of the loan market , especially 
for call loans. This includes both the interest rate and the attitude 


162 


RISK AND RISK-BEARING 


of bankers toward speculative collateral, affecting the proportion of 
market value of stocks which can be borrowed upon them. The 
speculative markets are absolutely dependent on the banks for funds. 
Margin buyers pay interest, short sellers pay none; hence an advance 
in money rates strengthens the bears and weakens the bulls. Con¬ 
versely, an advance in the market increases the demands on the banks, 
partly because the same stocks are now good collateral for larger 
loans and partly because advancing prices generally stimulate an 
increase in speculative interest. 

For these reasons the call-loan rate is very generally regarded as 
a valuable index of the strength of the market, a rise in the rate 
tending to force liquidation and therefore forecasting a decline in 
prices. 

The importance of this factor is very much overestimated, how¬ 
ever. It takes only a very small fluctuation in the price of a security 
to offset the interest cost of several weeks’ waiting, and even a doubling 
of the call-loan rate would rarely make the difference between profit 
and loss on any except very long-time speculations. Anything which 
is generally believed to affect prices will have some effect on them 
simply because the effect is anticipated, and the call-loan rate is 
so emphasized by financial writers that it can hardly fail to have 
some sentimental effect, but its practical importance is slight. 1 

2. The amount of the floating supply of speculative securities , i.e., 
stocks in the hands of brokers, most of which are likely to come on 
the market as a result of comparatively slight changes in price. This 
floating supply, it will be noted, determines whether the stock can 
safely be sold short. A small floating supply makes the position of 
the short seller precarious; many stocks cannot be borrowed for short 
sales at all. 2 

3. The proportion of the long stock which is weakly held , i.e., held 
on small margins or held by people who are interested in taking quick 
profits and cutting losses short, as compared with the proportion of 
stock which is known to be held for purposes of control or by investors 
who are not at all likely to sell or lend the stock. 

1 Mr. L. D. Thompson has shown (The Relation of Call Money Rates to Slock 
Market Speculation , a thesis submitted in candidacy for the degree of Master of 
Arts at the University of Chicago, 1922) that there is no significant correlation 
between call rates and the volume of trading on the New York Stock Exchange, and 
his data seem to indicate also a lack of correlation between call rates and prices 
though the latter question is in need of further investigation. 

3 See p. 138. 


STOCK SPECULATION AS BUSINESS ENTERPRISE 163 

4. The size of the 11 short interest ” (number of outstanding loans of 
stock to short sellers). 

5. Location of stop-loss orders and resting orders. 

6 . The state of speculative sentiment on the part of the public; the 
amount of free capital controlled by the section of the public who 
display an interest in the market. 

Judging the technical position is not easy .—Of these seven elements 
only the first is readily ascertainable. The data most commonly 
employed in the effort to judge the others are: 

1. Loan rates for stocks . 1 When the loan rate is low, or a stock 
loans “flat,” or at a premium, the presumption is that there is a big 
short interest in that particular security. This may plausibly indicate 
that there is a preponderance of expert judgment to the effect that the 
price is too high and is likely in the long run to fall. Its immediate 
significance, however, is just the opposite, for it indicates that there 
is a big group of prospective buyers made up of those who have already 
sold short. They will have to buy at any price if their margins are 
endangered by an advance, and will probably buy to obtain their 
profits if there is a decline. Hence, the technical position is judged 
to be “strong.” Too much confidence should not be placed in this 
reasoning, however, for the floating supply may be increased at any 
time by the sale of loan of stock which has been held outside the 
“Street.” (For further discussion of this point see pp. 166-67.) 

2. Public interest , as manifested by the size of the crowds before 
the brokers’ blackboards, and the volume of orders on their books. 
Increasing interest on the part of the people is likely to presage 
increased buying power, as the public always comes in after a dull 
market as a group of buyers rather than short sellers. Such an 
increase in public buying, however, may be the signal for a wave of 
delayed selling by professional speculators, pools, or insiders in the 
management of corporations who have waited for just such an oppor¬ 
tunity to unload their holdings. 

3. Volume of transactions , as shown by the ticker tape. 

4. Continuity of quotations and variation of the volume of trade 
from day to day. 

5. Charts , calendar schemes , and other mechanical forecasting devices. 

These last three methods, which comprise the favorite field of the 

modern alchemist, may be discussed together. Of schemes to forecast 

1 See p. 139. 


164 


RISK AND RISK-BEARING 


the action of market by studying the record of prices and volume of 
sales as it appears on the ticker tape or in the daily papers, there is 
no end. Few features of modern business have received more minute 
study than has been devoted to the attempt to work out a mechanical 
method of judging from the present and past condition of the market 
what its future is going to be. “Tape readers” study the fluctuations 
of prices from hour to hour, record the volume, and attempt to fore¬ 
cast the immediate future, trading for profits of an eighth to a half 
point. Chart artists trace the movement of prices of selected groups 
of stocks and attempt to draw conclusions from the shape of the curve. 
“Calendar traders” scrutinize the stock-exchange quotations for 
evidence of seasonal tendencies, and express their conclusions by such 
phrases as the “January rise,” the “spring rise,” etc. Most of this 
sort of study is obviously wasted effort. The generalizations are 
usually based upon the experience of a comparatively short period, 
five or seven years in the case of the calendar trader and six or eight 
coincidences in the case of the chart plan. Even if such coincidences 
are not accidents, but due to some continuing cause, it does not 
follow that this unknown force will continue to produce the same 
effect. If no other force comes in to change the future, the very 
fact that a regularity is great enough to be observed by numerous 
traders constitutes a force disturbing the sequence of price movements 
in the future. If, for instance, there is a tendency for several years 
in succession for stocks to rise in January, 1 perhaps on account of 
dividend disbursements reinvested around January 1, the more 
regularly the phenomenon appears, the more certainly will there be 
a bunching of purchases just ahead of the date when the rise is due in 
order to sell on the rise; and these operations may cause the rise to 
appear earlier and to be followed by an earlier decline. It would be 
rash indeed for anyone to say that none of these mechanical methods 
has any value, for no one has tested them all, and the more valuable 
any method proves itself to be the less likely are its discoverers to give 
it publicity. So far as can be judged, however, from a survey of the 
rather extensive literature of stock speculation, there are few less 
promising ways of making an income than attempts to “beat the 
tape” by a study of the tape itself. 

It does not follow, however, that a study of the data revealed by 
the tape is of no significance whatever in forecasting the course of 

^he careful studies published by the Harvard Committee on Economic 
Research in the Review of Economic Statistics indicate that there is no seasonal 
fluctuation in the prices either of industrial stocks or of high-grade bonds. 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


16S 

prices. There are apparently certain relationships between the 
volume of trading and the course of the typical stock-exchange 
cycle which are useful as a supplement to other methods of analysis. 
The following quotations summarize all that, in the author’s opinion, 
can safely be said with regard to this phenemenon: 

How much attention, if any, should the “investor for profit” pay to 
the stock market from day to day or from week to week ? Has he anything 
to gain from watching current fluctuations and volumes, or studying the 
general behavior of the market ? 

We may answer at once that he should pay relatively little attention 
to these things. Earnings and values, growth of population and of business, 
dividends and money rates, political conditions and the accumulation of 
capital in the banks, are of far more importance and significance to the 
investor than any indications he can draw from the temporary and often 
erratic fluctuations of prices. 

Yet this question of the action of the market should not be entirely 
ignored. It is a well-known fact that some professional speculators are 
able, by carefully watching the technical indications derived from a study 
of volumes and prices, to make more money during the year than they lose. 

Reduced to its lowest terms, the action of the market includes only 
three basic factors: (i) price; (2) time; (3) volume; that is, the number 
of shares bought and sold at a certain price or during a certain time. 

Each of these three factors may be recorded or used in different ways, 
and the three, or any two of them, may be combined according to different 
plans. 

First, no important conclusions can be obtained from any one of the 
three factors, taken alone. It is the varying relations between two or three 
of them that serve to give the market a sort of character of its own. 

Second, the element of time must always be included. Thousands of 
students have wasted a great deal of more or less valuable brain-power in 
trying to draw conclusions from a combination of prices and volumes, 
without reckoning in the lapse of time. In my opinion, it can’t be done. 

Third, a study of time and volume without prices would be meaning¬ 
less, as the investor cannot buy or sell except at some price. 

Common sense tells us that the lowest prices are likely to be made when 
most people are trying to sell, and the highest prices when the greatest 
number are anxious to buy. We shall expect, then, that the volume of 
sales will be relatively large at the top and the bottom, and this conclusion 
is borne out by history. 

A heavy trade in stocks is pretty sure to be accompanied by relatively 
wide fluctuations in prices—the whole market gets bigger, in every way. 
So we find that at these turning points the range of prices for the day, as 
shown by the length of the lines on the graphic connecting the average 
high with the average low, will be relatively wide. 


i66 


RISK AND RISK-BEARING 


After a period of heavy selling pressure, buyers are not likely to rush 
in the moment the selling ceases. They fear a renewal of the liquidation, 
and will only begin to buy gradually, as the market becomes quieter and 
more settled. Consequently a period of activity—that is, big volumes and 
wide daily ranges—at low prices, is usually followed by a time of dullness 
without any very great change in the general level. 

The same principle, of course, applies after great activity at high prices; 
but the period of activity may be longer and the period of dullness shorter 
than at the bottom, because speculation is naturally broader at high prices 
and the public participation in the market more general. 

Probably the best indication of the trend of the market, that is easily 
available to everybody, is found in the comparison of the total volume of 
trade on days when the market moves sharply upward, and the volume on 
declines. In a bull market, buyers come in on the advances. In a bear 
market, they refuse to do so. In a bear market, holders are urgent to sell 
on declining prices. In a bull market, they hold on stubbornly. 

The result is that, in a bull market, the volume of trade is likely to 
increase on the advances, while in a bear market it will probably become 
heavier on declines. But this principle can only be interpreted and applied 
to the market by long study and careful observation. The novice finds 
many stumbling blocks. 

One of them is that he is almost sure to lay too great weight on small 
movements, caused only by professional operations. Professional traders 
make prices temporarily, but they have very little influence on the general 
trend of prices over a considerable period. They are merely trying to follow 
this trend, not to make it. The attitude of investors creates the trend, and 
no useful indications as to its direction can be gained from fluctuations 
caused only by professional speculators. 1 

The difficulties involved in attempts to predict the market’s 
course on the basis of its own action are summarized by an experienced 
trader as follows: 

It might be supposed that the borrowing demand for stock would serve 
as an indication of the extent of the short interest, but as a matter of fact 
it is of little value in that direction. In the first place, the borrowing may 
be by a short interest of an “investment” character, which cannot be 
driven to cover and therefore does not create an “oversold” market in the 
ordinary sense of that word. 

Second, the stocks borrowed may be to temporarily take the place of 
long stocks sold by previous holders whose certificates have not yet arrived 
in New York from abroad or from other cities, or even for holders who have 
delayed getting their certificates out of their vaults and delivering them. 

1 Taken by permission from G. C. Selden, Investing for Profit , 137-48. (Maga¬ 
zine of Wall Street, 1913.) 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


167 


A large interest may sometimes prefer to have its liquidating sales appear 
to be short sales until it has disposed of its entire line, thus avoiding any 
premature filling up of the Street with certificates, which might help to 
depress prices. 

How then are we to find out the amount of the short interest ? Some 
line on the situation can be obtained by talking with active brokers. True, 
the broker can only express his opinion, formed from such opportunities 
for observation as he may have. For that reason, his words cannot be 
accepted as gospel. In fact, it will often happen that one broker thinks 
the market is oversold while another sees no special evidence of any extended 
short interest. Nevertheless the broker has a much better opportunity 
of getting this information than the outside investor, and his opinion should 
be duly considered. 

Coming to the position of big operators, this is as a rule very difficult 
to ascertain and the average outside speculator can rarely allow himself 
to be much influenced by it. Most of the gossip floating around the Street 
as to what Morgan, Kuhn-Loeb, or the City Bank is doing in the market 
is worse than valueless. 

The task of finding out what big interests are doing in the market is 
not absolutely impossible, but it is almost as difficult as learning to judge 
the market correctly yourself. For that reason your main reliance must 
always be on yourself, and such reports are always to be regarded 
suspiciously. 

Sincere reports from the floor as to the position and sentiments of the 
majority of the traders are not usually very difficult to get from your 
broker, but I am obliged to admit that I have never got much benefit from 
them. Floor traders rarely agree in their views and as their opinions are 
usually formed from the surface indications which flicker back and forth 
before their eyes, their sentiments are likely to change with a suddenness 
and completeness which are confusing to the outsider. They willingly 
report what they see, but I doubt very much whether the outsider can make 
much profitable use of their reports. 

The presence of stop orders above or below the current plane of 
prices will, if they are in any considerable volume, have a decided effect on 
the trader’s position. The first question in this connection is: How are 
we to discover whether such stop orders are present or not ? 

The reports on this subject which are from time to time heard floating 
around the Street, or are ’phoned by customers’ men to their more active 
following, are hardly ever to be taken at their face value. This is chiefly 
because actual information about stop orders is, as a rule, unobtainable. 
Reports on the subject are pretty sure to be guess work. 

Of course the most important stop orders are not put on the floor. In 
fact they usually do not exist anywhere except in the mind of the operator. 





i68 


RISK AND RISK-BEARING 


He has, let us say, a big line of Steel common. He makes up his mind that 
if Steel declines to 62 he will close out his line, as that much decline would 
indicate to him that his judgment of the situation has been wrong. 

Such a determination on the part of the operator is exactly equivalent 
to a stop order on his holdings of Steel at 62; but there is no record of that 
determination anywhere, and no possible way of getting information about 
it in advance. The operator does not tell his broker to put a stop at 62, 
because he very well knows that such a course would invite attack. If 
through any “leak”—and it is very difficult for any brokerage house, no 
matter how honorable, to stop all possible leaks—the fact became known 
to the floor traders that a big line of Steel would be stopped out at 62, they 
would all be expecting the price to decline to 62, and would therefore 
hesitate to buy even if they did not take the short side. The small trader, 
of course, need not hesitate to put in his stop in advance. He is merely a 
fly on the wheel, and his position will have no perceptible effect on the 
market. 

You always have to remember that when you feel a certain way about 
the market, a lot of other people are feeling just the same way. What you 
have to do is to be a little bit cleverer than the others—for example, to 
buy when the stop orders are executed around 150. Then you can safely 
enough put in your own stop at perhaps 149 after the market has turned 
upward. But it takes you a number of years to get to be cleverer than 
others—cleverer than the market, in other words—and in the meantime 
you are very likely to put your stop in the wrong place. 

In a general way we can get some idea of the situation by noting whether 
transactions increase or decrease on the declines. Short sales may, it is 
true, produce a moderate and temporary increase in business on declines, 
but any important or persistent increase may always safely be set down as 
evidencing sales by actual owners of the certificates. In order to do more 
business at lower prices, traders and speculators must very soon get hold of 
more stock which may be bought and sold. If instead of finding more 
stocks in the floating supply after a decline they find fewer stocks, transac¬ 
tions will quickly shrink and a trapped short interest will soon have to buy 
back its sales at higher prices than where they were put out. 

Suppose prices decline rapidly on a big volume of trade for perhaps two 
weeks, with relatively wide fluctuations in the leading speculative stocks 
from day to day. Then from near bottom prices we have a sharp rally 
for several days, caused by covering of shorts. After that the market 
grows dull and drifts slowly downward for two or three weeks, with transac¬ 
tions much smaller than on the previous decline and with a narrower range 
of daily fluctuations. This is a plain case, and it generally occurs in sub¬ 
stantially the way above outlined several times in every year. It shows 
three steps, which always occur when the market strikes bottom and turns 
upward: 



STOCK SPECULATION AS BUSINESS ENTERPRISE 169 

(1) Liquidation by investors and traders who have become discouraged, 
either by the unfavorable outworking of the whole situation or by specific 
bear news. 

(2) Partial cessation of such liquidation, quickly followed by covering 
of shorts which had been put out during the decline, causing a rally. 

(3) A period of rest, accompanied by a small amount of left-over 
liquidation and by scalping short sales, the latter practically all by pro¬ 
fessionals and semi-professionals. 

After this process the market is ready to respond to favorable news when 
it comes, and will decline but little on further bear news, unless it is of a 
very sensational character. 

What has really occurred is that the floating supply of stocks, which had 
been increased by liquidation, has little by little been absorbed. Some 
investors were buying on a scale during the first decline. Others bought 
when they thought the market has turned. Still others were busy picking 
up stocks during the third period above described, so that every evidence 
of temporary weakness resulted in scattering buying orders . 1 

Trading on the news involves great risks .—The second great method 
of speculating for the short swing is trading on the news. There is no 
place in the world where so much attention is paid to the gathering, 
dispensing, and study of the current news as in the speculative invest¬ 
ment markets. Outside of the news of sports, the want ads, the 
divorces, and the crimes there is little in the daily newspaper which 
does not have a bearing on the incomes of businesses, big and little, 
and hence upon the value of securities. But the newspaper is too 
slow and too little specialized to meet the demands of the speculative 
public, so an elaborate system of specialized information service has 
been developed. Of this apparatus, the most important parts are 
the news ticker, the Bulletin Service, the market letters, and the 
reviews furnished by the professional financial service bureaus. Of 
these, the quickest is the news ticker or broad-tape service, a collection 
of bits of general political and economic news, corporation reports and 
brokers’ gossip, which is sent out over leased telegraph wires and 
printed simultaneously in every important brokerage office in the 
country. 

Slightly slower than the ticker, but fuller, is the hourly or half- 
hourly Bulletin Service published in eastern cities. Some brokerage 
houses issue daily market letters which purport to explain the action 
of the day’s market and make cautious predictions of the nearby 

1 Adapted by permission from Browne, Practical Points on Stock Trading , 
35-49, 55-64. (Magazine of Wall Street, 1918.)' 


RISK AND RISK-BEARING 


170 

future; others issue more pretentious weekly reviews which discuss 
the general economic situation and also summarize the known facts 
concerning the situation of individual companies. 

Trading on the general news is simpler than trading on the tech¬ 
nical position, and looks, at first glance, to be a more sensible pro¬ 
cedure. “Values are subject to constant change,” runs the reasoning 
back of this method of procedure. “The changes all have causes, 
and these causes must in large part appear in the news. Trading on 
the news after everyone has it obviously promises no profits; the 
important thing is time. Our business is to anticipate other men’s 
decisions to buy or sell, and to do this we must get the news before 
they do.” This reasoning is sound enough, yet there is no reason to 
believe that people who make a practice of buying Bulletin Services 
or frequenting brokers’ offices to keep in touch with the latest informa¬ 
tion actually make money by so doing. A fourfold difficulty obstructs 
all attempts to make money in this way. In the first place, the impor¬ 
tant news, the items that will cause a real change in the level of stock 
prices, such as supreme-court decisions or declarations of war, are 
known to a great many people before they appear even on the broad 
tape, and are pretty accurately anticipated by a great many more, 
so that even the most studious frequenter of the broker’s room is apt 
to be too late. In the second place, speed is gained in these services 
at the sacrifice of accuracy. Like the daily press, the news services 
abound in unverified rumors, some of which are probably put out for 
the deliberate purpose of influencing the market, but many merely to 
fill space. In the third place, on nine out of ten days there is no news 
of sufficient importance to justify anybody in changing his market 
position, and in the absence of really significant news the tape and 
the bulletins are filled up with actual information which is indeed more 
or less relevant to the general financial situation but is so slight in its 
significance and so great in its mass that it creates only confusion. 
Finally, the Wall Street news services are themselves read by so many 
people that any given individual finds it difficult to profit greatly by 
being one of those who get the news through them. Prices adjust 
themselves to the known elements of a situation with astonishing 
rapidity, and there is no commoner error than trying to make a profit 
by trading on news which is already fully discounted before one’s 
order comes to the floor. 

The following comment, by the editor of a prominent financial 
journal, summarizes the situation well: 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


171 

So far as the news is concerned, there are two kinds: known and 
unknown. Known news is what we find on news slips, news tickers, news¬ 
papers and the usual run of market letters. Known news is what has hap¬ 
pened and has been told. It becomes public property the moment it is 
printed in Wall Street. News known to everybody is, except in rare cases, 
of little use to anybody. Yet the great public thirsts for news, talks news 
and trades on news. Market letters of brokerage houses are practically 
all based on an analysis of known stock market factors; also newspaper 
financial articles and “reviews and outlooks.” 

One need spend but a few months in Wall Street to find that the move¬ 
ments of the market 1 cannot consistently be reconciled to the news, statistics, 
earnings, outlook or such other considerations as largely influence the general 
public. Almost every day we see the market advance on bad news or break 
in spite of favorable developments. It is impossible to analyze the effect 
of a certain situation upon the minds of a million people who are interested 
in the market, either as investors or as speculators. Wall Street is a great 
“hopper,” into which all day long there pours an unceasing stream of news, 
statistics, decisions, railroad and industrial reports, Government estimates, 
court rulings, corporation announcements, and last, but not least, rumors 
and tips. 

All this news and all these facts and rumors and tips which are poured 
into the “financial hopper” have a certain influence on the minds of traders 
and investors, causing them (directly or indirectly) to buy or sell. 

We frequently notice squibs in the papers to the effect that “ the advance 
in Reading was due to the company’s favorable monthly report,” or some 
expression of that kind. One can readily see how impossible it would be 
for the reporter who writes this paragraph to ascertain just why those who 
bought and sold during the day, did so. In order to make such a statement 
with any degree of accuracy it would be necessary to communicate with each 
buyer and seller for the day, extract from him the reason why he made the 
trade and strike a balance. These buyers and sellers may be scattered all 
over the earth, dealing in one, ten, fifty or one thousand share lots. It is, 
therefore, absurd to place any reliance on statements that this or that was 
the cause of the advance or the decline. This not only emphasizes the 
necessity of taking newspaper reports with a grain of salt, but proves that 
no one actually knows what produces these small advances and declines, 
although there are a great many people who guess about it. 2 

Trading on 11 inside information ” is very common .—The third 
method of short-time speculation is trading on “inside information,” 

1 The reference is to short swings, not to the major changes which require months 
or years for their completion (ed.). 

2 Adapted by permission from Richard D. Wyckoff, “Why the Action of the 
Market Is a Better Guide than the News or the Fundamentals,” Magazine of Wall 
Street, March 19, 1921, pp. 709-10. 


172 


RISK AND RISK-BEARING 


that is, information not yet available to the general public. The only 
generalization which can be made, with reference to the value of this 
sort of material, is that it all depends on the source from which the 
information comes. The vast majority of the so-called tips which 
float around the customers’ rooms of the brokerage offices are worth¬ 
less. Especially is this true of the information in regard to the doings 
of prominent operators, a popular basis of trading among small-fry 
speculators. On the other hand, advance information of the condi¬ 
tion of corporation reports, and of changes in the dividend policy of 
important corporations, is nearly always available to a sufficient 
number of people, so that its market influence is shown from one to 
three or four days ahead of the public announcement. Boards of 
directors have often been severely criticized on account of stock-market 
movements, which indicate that they have themselves operated on 
the knowledge of their own actions to the detriment of other stock¬ 
holders, 1 or have improperly given advantages to a favored few. The 
directors are not always at fault, however. There are many other 
chances for leaks. Employees of public accountants’ offices often 
know the essential features of a corporation’s annual statement before 
the officers of the corporation know them. Stenographers and tele¬ 
phone operators must be taken into the confidence of the management. 
Tips from such sources as these may exercise an influence in the market 
for which the directors are blamed. However, there is no reason to 
doubt that many corporation directors do consider it legitimate for 
them to trade in the securities of their own corporations on the strength 
of their advance information. To quote Mr. Wyckoff again: 

Unknown news consists of important facts in possession of a few insiders. 
It is the possession of these facts which distinguishes the insider from the 
public. The insider works with an incalculable advantage. Reports of 
earnings, probability of reduced or increased dividends, etc., must be known 
to some one person or a few, before public announcement can be made. 
This may take place a few minutes, hours, days or weeks later, according 
to market conditions and the position of the insiders. Meantime those 
who trade on the news which is known are simply playing into the insider’s 
hands. 

The insider does what probably you would do if you were in his place. 
During the interval between his receiving and announcing the news, he 
telephones his broker and gives his order. This takes but a moment. If 
he is a big enough factor, some manipulation may accompany his buying 

1 The Rock Island receivership was a comparatively recent case in point. 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


173 

or selling; but whether his operations are large or small, there is usually 
a coterie of associates who act with him or upon his information. 

Each of the persons composing this group has his own broker, and each 
broker his own clientele. It is customary for a broker who sees inside 
orders coming through, to advise certain of his clients in accordance there¬ 
with, without necessarily disclosing the actual source. For example, the 
broker will say, “Now Jones, I want you to buy some of this stock. I can’t 
tell you what I know, but there is excellent buying going on, and if you will 
take on a little, I believe you will make some money.” Thus unknown 
news becomes the power behind a movement which may attain large pro¬ 
portions before public announcement is made—when the unknown news 
becomes known news. 

However desirable this unknown news or “inside information” may be, 
getting it from its original sources is beyond the reach of the average trader. 
And even if he had “underground” connections with every important source 
of information in the Street, there would be no certainty that he could always 
profit thereby. Insiders are often completely surprised and suffer heavy 
losses on account of an adverse trend of the market, some other and more 
effective news, an accident or the operations of opposing speculative pools 
and large individual traders. One clique may possess a bit of knowledge 
which, in their opinion, will produce a certain market effect; another 
group may command greater resources, swing larger lots, diffuse more 
effective “information.” Group One may, therefore, find its efforts futile. 

Then we must consider the “sentiment” of the Street, which is fre¬ 
quently more powerful than any group of operators. In former years, 
manipulators able to swing fifty or a hundred thousand shares could practi¬ 
cally dominate the market; but in these days of hundred million dollar 
issues and billion dollar capitalizations, everybody is stronger than anybody. 
At such times “inside information” is likely to ruin one who follows it in 
the face of overwhelming buying or selling by the public. In other words, 
insiders are not invariably correct. It is an old saying that “inside informa¬ 
tion” will break anyone. 1 

“ Manipulation ” is difficult to detect .—The fourth method of 
speculation for the short turn is manipulation, by which we mean all 
operations aiming at a profit from a change in the market which the 
operator himself causes, either by the sheer weight of his own opera¬ 
tions or by coloring the news, or often by a combination of both 
methods. Manipulation is only possible through large-scale opera¬ 
tions, and the number of people who can engage in it is comparatively 
small, though, by pooling their capital and intrusting the management 
of their campaign to a single manager, a group of individuals can 


1 Loc. cit. 


174 


RISK AND RISK-BEARING 


/ 


influence the market as much as a single operator owning much larger 
capital. Such pool operations are probably very common, but au¬ 
thentic information concerning their activities seldom reaches the pub¬ 
lic. The following reading describes typical manipulation methods: 

There may be said to be three principal forms of manipulation, apart 
from those that were formerly conducted through what are known as 
“wash sales” and fictitious transactions, which have largely been abandoned, 
and others which it will not be necessary to discuss. 

1. The most common and most vicious form is effected by what are in 
substance bogus purchases and sales to create a false appearance of activity 
for the purpose of unloading the stock on the public at high prices. The 
same person or group gives buying orders to one set of brokers and selling 
orders to another but the selling orders exceed in volume the buying orders 
until the stock is marketed. The apparent purchases and sales may and 
often do exceed the actual purchases by the public ten or twenty over. In 
order to actually unload one hundred shares on the public the manipulator 
may have to apparently deal in thousands of shares. So long as commissions 
are paid on these sham transactions on both sides of the bargain the Exchange 
has regarded them as entirely legitimate, even though the real nature of 
the dealing is apparent from their volume and from general report and can 
readily be verified from the books of the brokers, to which the Exchange 
has free access at all times. 

2. A series of transactions conducted for the purpose of acquiring or 
selling a large block of the stock of a given corporation not for investment 
but with the intent of realizing an immediate profit, brought about by 
purchases and sales that are calculated to affect the price in the way best 
adapted to accomplish the end in view. If the purpose be to accumulate 
stock so as to sell at a substantially higher level, the plan involves selling 
part of the accumulations as the stock rises so as to depress the price and 
then make larger purchases. If the intention is to sell the opposite course 
is adopted. The ultimate object is to buy stock that you do not want or to 
sell stock that you do want with the view of affecting the price. 

3. Where a new security is to be introduced, instead of advertising its 
merits by the publication of a prospectus or by open solicitation, the security 
is here again given a false appearance of activity to attract dealings. After 
the public has been led to buy on the assumption that it is acquiring a 
security with an active market that is readily saleable, those who were 
interested in creating this impression and who have probably disposed of 
the stock they had to sell find it unnecessary to continue the heavy expense 
of paying out commissions on what are in effect fictitious transactions, and 
the buyers’ apparently active market gradually and sometimes suddenly 
fades away. 1 

1 Taken by permission from Samuel Untermyer, “Speculation on the Stock 
Exchange,” Supplement to American Economic Review, March, 1915, pp. 47-48. 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


175 


Concerning the profitableness of this type of speculation, no 
authoritative statement can be made, as the facts about success¬ 
ful attempts at manipulation are never made public, and those con¬ 
cerning unsuccessful ones only rarely. The risks involved are obvi¬ 
ously large, but whether the profits compensate for the risks undergone 
we do not know. 

Even the trader who is correct in the majority of his forecasts is likely 
to lose more than he makes. —If all trades made by a given individual 
are of the same size, and he follows a uniform rule as to the size of 
the profits or losses for which he will wait before closing out trades, 
the odds against him are small. Making trades purely at random, 
the average number of profitable trades, ignoring commissions and 
similar expenses, would be 50 per cent of the total number of trades, 
and in the long run the net loss should therefore equal the total amount 
of commissions and expenses. The average trader would probably get 
about the same result by following the news and exercising his 
judgment. 

If the trades are of the “scalping” type the commission is a very 
heavy percentage of the profit aimed at, and a very large excess of 
successes over failures must be attained in order to avoid speedy ruin; 
if the trader holds out for five- or ten-point gains or losses, on the 
other hand, a slight preponderance of successes will more than offset 
the commissions and other expenses. 

The overwhelming difficulty is that it is almost impossible to avoid 
methods of trading which make the average loss greater than the aver¬ 
age gain, so that the trader may be right six or seven times out of 
ten and still be forced to quit a loser. The reason for this is the incor¬ 
rigible tendency to expand the scale of operations after a success and 
to contract it after a loss. Most speculators are supplied with small 
capital in proportion to the volume of their customary trades—if this 
were not true the privilege of trading on margin would be of little 
value, except to the short seller. Suppose a speculator begins trading 
with a capital of $2,000, and to be conservative decides to buy on a 
twenty-point margin stocks which his broker would be willing to carry 
on ten points. He buys 100 shares of Southern Pacific stock, which 
he sells at a five-point profit, clearing about $465. He repeats the 
operation, making five and a half points, and has now increased his 
capital to nearly $3,000, and can trade in 150-share lots quite as safely 
as he could trade in 100-share lots at first. Either by “pyramiding” • 
or by collecting his profits and reinvesting them he can, so long as all 


176 


RISK AND RISK-BEARING 


goes well, rapidly increase the scale of his operations and correspond¬ 
ingly increase the rate at which his profits pile up. If all his forecasts 
are correct, there is no way in which a small capital can be built up 
into a large one so quickly. But if part of his trades result in losses, 
as they certainly will, the losses will be sure to come at the times 
that the trades are largest. On the other hand, if the first few trades 
result in losses and it becomes necessary to curtail the scale of opera¬ 
tions, then on the smaller scale of operations a larger number of success¬ 
ful trades must be made in order to recover what has been lost. If 
the trades are originally so large that the trader is in fear of being 
sold out on a decline, or if stop-loss orders are used, the probability 
of making bigger average losses than profits is accentuated. In the 
author’s opinion, this adjustment of the size of the trade to the volume 
of accumulated profits or losses is by far the most important cause 
of the excessive proportion of losers among speculators. The only 
real defense against it, aside from avoidance of the market, is to keep 
the trades so small in proportion to the capital actually used or avail¬ 
able that the gain or loss from an accidental succession of good or bad 
forecasts will have no appreciable influence on the scale of operations 
which can safely be undertaken. 

The probabilities of success in short-swing speculation in stocks are 
small. —In summary of our conclusions on this topic, it may be said that 
speculation in stocks, with a view to profiting by fluctuations in prices, 
affords one of the best examples of what the economist calls entrepre¬ 
neurship, i.e., the quest of pure profit, and income made possible by 
the presence of uncertainty. The profit of the successful enterpriser in 
this, as in other forms of risk-bearing, depends on the presence of one 
of three situations— knowledge of the outlook superior to that of others 
who are rival seekers for profit from the same source, ability to control 
the factors on which the outcome of the venture depends, or sheer 
superiority of luck. A few major operators may have some degree 
of control over the movements of the whole market, and a consider¬ 
able number of business men have some control over the prices of the 
securities of the corporations with which they are connected; the rest 
of the speculative fraternity must depend on knowledge or on luck. 
Of these, again, a few have access to “ inside infomation” which 
enables them to trade with the odds in their favor, while the majority 
must rely on their superior sagacity in interpreting the news which 
• they share with thousands of others. Under these circumstances the 
amount of luck involved in the outcome of a particular venture is 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


177 


necessarily enormous, and the popular confusion of speculation with 
gambling has a large degree of justification. 

Speculation for “ long-swing ” profits involves fewer unavoidable 
uncertainties than does speculation for the tl short-swing ”—The opera¬ 
tions of the speculator who tries for large profits on a slow turnover 
are of an entirely different character from the type of speculation which 
has been discussed in the preceding pages. Changes of 40 or 50 per 
cent in the value of the higher-priced and safer securities, and of 
several hundred per cent in the lower-priced and more speculative 
issues, often take place within the course of a year or two, and traders 
who successfully forecast these changes may make correspondingly 
large profits without the futile and nerve-wrecking experience of watch¬ 
ing for indications of the minor and quite inexplicable fluctuations 
which occur from day to day. It is true, of course, as in every other 
form of speculation, that it is impossible to profit except by superior 
luck or skill, that there is always a losing as well as a winning side, 
and that of a large number of trades the losses must always exceed 
the gains by the amount of the commissions, taxes, and other expenses, 
so that there can be no such thing as a permanent science of specula¬ 
tion. As fast as such a science became generally known it would 
become obsolete. In the present stage of development of the business, 
however, it appears probable that the fundamental facts, which are 
indeed accessible to all those who put their money into the market, 
are studied with care by a sufficiently small proportion of them so 
that there is a fair chance that those who do base their opera¬ 
tions on something approaching the character of a scientific study 
will profit at the expense of those who do not. In so far as this is 
true, it is undoubtedly the operator for the long swing who has the 
advantage. 

Analysis of the long-range outlook for security prices takes two 
forms, namely, the study of the outlook for individual firms and the 
study of the trend of the market for large groups of security prices. 
Those who practice the first type of speculation talk and think in 
terms of balance sheets, income statements, unfilled orders, changes in 
personnel, and similar evidence of the prosperity and prospects of 
individual firms. These are the bargain-hunters of Wall Street. 
Their special objective is to find securities of relatively inconspicuous 
corporations which have passed through a period of improvement 
whose effect on the value of the securities has been overlooked, so 
that the securities may be bought below their true value, or, vice 


178 


RISK AND RISK-BEARING 


versa, to find securities of corporations which have a good reputation 
based on past performance but are going backward, so that the securi¬ 
ties are selling at a price too high to be justified by the present outlook. 
Such traders have no interest in safe bonds or stable stocks once the 
public has become convinced of their safety and stability. 

The methods of analysis employed by the bargain-hunting type 
of speculator are in general identical with those employed by capital¬ 
ists who are looking for a permanent investment for income. Espe¬ 
cially is the investor who is trying to secure yields above the market 
rate for safe investments similar in his objectives and methods to 
the bargain hunting type of speculator, for the security which con¬ 
tinues to yield an abnormally high return is nearly sure to advance 
in price. 

Investors for income, even those who are disposed to take specula¬ 
tive chances for the sake of the high yield, characteristically pay for 
their stocks in full and take them out of the market, while the indi¬ 
vidual who is planning to close out his trade on a market fluctuation 
is very likely to buy on a conservative margin. Moreover, the long- 
swing speculator is ready to take short side, in case the securities of 
a given corporation are overvalued, while the investors’ bargains have 
to be found in cases where the securities are undervalued. This differ¬ 
ence in methods of operation, however, does not involve any important 
difference in the method of arriving at conclusions concerning the 
strength of the corporations or the soundness of their issues. 

Discussion of the methods used in analyzing the position of indi¬ 
vidual firms and the strength of particular securities with a view to 
profiting by changes in their prices is therefore deferred to chap¬ 
ter x, where attention is given to the whole problem of investment 
analysis. 

The other type of long-swing speculation looks not at the record 
of the individual corporation but at the future of the market as a 
whole. Followers of this method talk and think in terms of the 
general level of prices, the effect of changes in the interest rate on 
the price of bonds, the amount of bank reserves, the volume of pig- 
iron production, and similar “fundamentals.” For the purpose of 
this group of speculators, the most desirable stocks are those of 
corporations whose prospects are the best known and least subject to 
change from agencies peculiar to the corporation itself. In practice 
this generally means the safer securities, not so much because the 


STOCK SPECULATION AS BUSINESS ENTERPRISE 


179 


trader is averse to taking risks as because these conservative securities 
are most likely to run “true to form” in accordance with the outlook 
for business activity and for the money market. 

This type of speculation depends entirely on the principles dis¬ 
cussed in chapter vi, hence needs no elaborate discussion here. The 
most important barometers are those discussed in connection with the 
money market. The long-swing speculator who depends on this 
type of forecasting keeps out of the market, except as a conservative 
investor, for perhaps four-fifths of the time, returning to it only when 
he believes that there are clear indications of an early change in the 
trend. His plan is to buy high-grade preferred stocks and the very 
best common stocks early in a period of liquidation, shift to more 
speculative securities late in a depression and again shift to short¬ 
term notes, or if he is less conservative, take the short side of the specu¬ 
lative market, at the height of a boom. Diversification is imperative 
in this method of operation, as any one security is likely to fail to 
follow the trend. 

The greatest difficulty in the way of this plan, aside from the 
extremely great difficulty in resisting the strong tide of optimism or 
pessimism which sets against an operator of this type, is the fact, to 
which reference was made in chapter vi, that the swings of the stock 
market are more numerous than those of the cycle of general business, 
and that there are no known formulas for forecasting the intermediate 
swings. Such a decline as that of 1917 is likely to catch the student 
of the cycle unprepared. 

The two methods of long-swing speculation are often combined .— 
Analysis of securities and analysis of the trend of the stock market 
are distinct but not conflicting methods, and those who practice the 
latter, as a rule, practice the former also. That is, they attempt first 
to determine when to enter the market either as buyers or as sellers, 
then decide what to buy or sell by study of corporation reports and 
the outlook for specific industries. Such bargain-hunting methods 
presumably offer the largest chance of profit, but involve more risk 
than is involved in the simpler method of sticking to the stocks of the 
best-known corporations and depending on diversification for safety 
and on choice of times to buy and sell as a source of profit. The weak¬ 
ness of the combination method is that an error in either the analysis 
of the security or the analysis of the market will involve the operator 
in loss. 


i8o 


RISK AND RISK-BEARING 


QUESTIONS 

1. A bought ioo shares of stock on January 4 at 91 and sold on 
February 10 at 94. Figuring commissions at $25.00, taxes at $4.00 and 
interest at 5 per cent, what was his profit? How would the profit be 
affected by a change of the interest rate on 90 per cent of the amount to 
10 per cent ? 

2. Examine the reports of the stock exchange trading in the press and 
list (a) the explanations offered for market changes; ( b ) the probable 
sources of information in regard to these reasons. 

3. Summarize the indications available to you regarding the future 
course of stock prices. Estimate probable amount of error in your forecast. 


CHAPTER X 

THE ANALYSIS OF SECURITIES 

As was noted in chapter vii, the investment of capital in businesses 
of others, or in government securities, presents one of the purest cases 
of an economic activity in which risk is the paramount consideration 
in determining the course of action. This is as true of the most 
conservative buyer of government bonds as it is of the most reckless 
stock-market operator. In each case, the problem is exactly the same; 
it is that of judging the probability of a favorable or an unfavorable 
outcome, and balancing the risk of loss against the return to be secured 
in the event of a favorable outcome, in order to determine which of 
two or more alternative employments of capital is the more attractive. 
The difference in the decisions of these two extreme types of conserva¬ 
tive and reckless buyers and of the innumerable intermediate types, 
reduces itself to ( a ) a difference of knowledge of the relevant facts; 
(b) a difference of judgment concerning the conclusions to be drawn 
from those facts; ( c ) a difference of attitude toward the bearing of risk. 

The formulation of an investment policy with regard to a particular 
security involves consideration of factors which may be analyzed as 
follows: 

I. Income factors 

a) The rate of income yielded 

1. Direct yield 

2. Yield to maturity 

b) Prospective increases in the rate of return 

1. Changes in dividend rates; issuance of “rights”; liquidation of 
arrears, etc. 

2. Prospective increases in market values 

3. Gains through calling of securities at premium above purchase 
price 

c ) Taxation 

II. Factors of risk 

a) Security of principal 

b) Certainty of income 

c) Marketability 

d) Diversification 

III. Indirect factors: control; prestige; access to desired information; 

social and moral objections to certain types of investment 

181 


182 


RISK AND RISK-BEARING 


The indirect factors are usually unimportant. —We may therefore 
dispose of the third group of considerations at once and pass to those 
which normally determine the decision. The cases where the direc¬ 
tion of investment is determined by collateral considerations of a 
social, moral, political, or business nature are relatively few, are highly 
diverse in character, and are of so personal a character that hardly 
any important general statements can be made about them. In 
theory, a type of investment which is avoided by numerous investors 
on account of social and moral considerations must pay a higher rate 
of return to secure its capital, and therefore should be unusually attrac¬ 
tive to those who are not disturbed by its unpopular aspects, but 
this factor is of no practical importance, so far as the investment 
market is concerned. It does have some influence in determining 
the rate of return for personal services and the profits of personally 
conducted businesses, but the investment market is too large and 
impersonal for prestige or social disapprobation to exert a visible 
influence upon it. 

The yields afforded by safe securities admit of exact comparison .— 
The technique of methods of figuring direct and maturity yields, effects 
of taxation on yield, and similar items with regard to securities 
regarded as safe needs no discussion here. These are questions of 
mathematics, not of business judgment, and are fully treated in the 
general literature of investment as well as in that of mathematics. 1 

The essence of the problem of relating price to yield, where risk 
is disregarded, is a comparison between the present and the future 
value of a stated sum of money. The market value of a safe security 
is the sum of the present worths of all the amounts to be received— 
principal, interest, dividends, rights, premiums, etc., discounted at the 
market rate of interest, and conversely the yield is the rate of interest 
at which the market price compounded will amount to the various 
sums payable under the instrument by the time they are due and paid. 
In the case of securities which pay normal rates of interest at ordinary 
intervals, the investor is relieved of the labor of calculation through 
the use of bond tables, while for irregular payments formulas are 
available which make the calculation purely mechanical. 2 

1 See, for example, Lagerquist, Investment Analysis; Chamberlain, Principles 
of Bond Investment; Jordan, Investments; Skinner, Mathematics of Investment. 

2 The use of these tables and formulas involves certain elements of error, none 
of which, however, are of great practical importance. The inaccuracies include 
the following: (a) Loss of interest on interest accrued at the time of investment: The 


THE ANALYSIS OF SECURITIES 


183 


Tax exemptions , so far as they are known when investments are 
made, involve a simple modification of the mathematical results of 
calculations of yield. They would be of no practical importance if 
they affected all investments alike, since the problem is always one 
of a choice between alternative employments of capital, but if these 
are differently affected by taxation the difference may be of very 
great importance. This is particularly likely to be true if, as at present 
in the United States, the same security or income is taxed differently 
in the hands of different holders. Thus to an individual who pays 
surtax at a high rate on his income, a fully tax-exempt bond bearing 
5 per cent interest is more attractive than a 6 per cent security with¬ 
out the exemption, while the small investor would suffer a loss if he 
selected the higher-priced security. * 1 


purchase price of bonds usually includes a pro rata share of the next instalment of 
interest; on this amount the investor loses interest until it is repaid at the next 
interest date. This results in a lowering of the actual yield, unless the securities 
are purchased on interest dates. The discrepancy is greatest if purchases are made 
at a time midway between interest dates. ( b ) Decimal approximation: The bond 
tables ordinarily used give interest yields accurate to the second decimal place. 
The maximum error which can result from this is $5.00 per $100,000 of principal 
in figuring interest for one year. Tables are available, however, which give results 
accurate to the cent for sums up to $1,000,000. (c) Rate of interest earned by 

reinvestment of amortization funds: Bond tables are constructed on the assumption 
that the payments to amortize the premium or discount are invested at the same 
rate as the yield on the security itself; this assumption is likely to be inaccurate. 
(1 d ) Time of reinvestment: This error is similar to the one just mentioned. The 
tables assume that all payments in amortization of premium or discount are rein¬ 
vested instantaneously; this is often impracticable. ( e) Interest interval: The 
assumption of the tables is that the amortization payments will earn interest pay¬ 
able semiannually; if interest is collected quarterly or annually a slight error 
results. (Cf. Chamberlain, op. cit., pp. 412-22.) 

1 In this connection, it may not be out of place to refer to the widespread 
fallacy that tax exemptions create a scarcity of capital for enterprises which can¬ 
not issue similarly tax-exempt securities, a fallacy which has recently appeared in 
highly respectable financial literature. Tax exemptions make a security less 
attractive to some investors and more attractive to others, but the financing 
of public enterprises through tax-exempt securities makes no larger drain on the 
capital resources of the country than would the financing of the same enterprises 
through securities subject to taxation. The tendency of tax exemption is to 
bring about a concentration of the securities so favored in fewer hands than 
would otherwise be the case, but unless it is believed that the public enterprises 
for which they are issued would not be financed at all without the exemptions 
it cannot be said that they operate to reduce the amount available for other en¬ 
terprises, or to increase the rate other enterprises must pay for their capital. 
This statement is subject to a slight modification on account of the greater 
selling cost involved in securing capital from the small investors to whom taxable 
securities are most valuable. 



184 


RISK AND RISK-BEARING 


Prospective changes in income, which are placed among the factors 
of income in our outline, may belong either here or in the category of 
risk factors, in accordance with the degree of certainty of their attain¬ 
ment. Future changes in dividend rates or in bond interest rates, 
the payment of accrued interest or instalments of principal, and other 
changes in nominal returns, if they are certain, are taken account of 
in figuring the yield or price at the time an investment is made, just 
as are the regular rate of interest and the amortization of the discount 
or premium on bonds. These payments involve no element of 
income to the investor, except the accrual of discount which was 
contemplated in the original price. On the other hand, prospective 
changes in income, whether increases or decreases, which are not 
regarded as certain, enter into the investor’s decisions as part of the 
factor of risk. Premiums on redemption, profits on resale, gains at 
maturity, and other irregular items, both certain and uncertain, come 
into the calculation in exactly the same way as do the ordinary pay¬ 
ments of dividends or interest. In each case, an income in the nature 
of interest arises from a discounting of the payments anticipated as 
certain, while economic profit or loss arises from the items not fore¬ 
known and hence not fully discounted and the market price at the 
time of purchase. The only difference is that the irregular items are 
less likely to be foreknown. 

Let us consider next the factors of risk. Security of principal and 
stability of income are very closely related. In theory, in many types 
of security, the safety of the principal depends on the value of property 
specifically or impliedly pledged for the purpose, while income is more 
directly dependent upon the earning power of the issuing organization. 
Practically, however, the distinction is rarely important. The value 
of property depends upon its income-producing power, and in default 
of earnings or other income out of which to meet interest payments, 
asset values crumble away. In choosing between ample property 
values and ample earnings, the latter should always be given 
preference. 

When the safety of principal and income in any investment is so 
great as to be a matter of general agreement, the yield is nearly sure 
to be low, but there are cases where by careful study and good judg¬ 
ment an income can be secured in excess of that usually obtainable 
on securities of similar strength. This is the chief object of invest¬ 
ment analysis. Success in identifying such opportunities affords 
opportunity not only for profit in the form of an income yield in 


THE ANALYSIS OF SECURITIES 


185 

excess of interest and replacement funds, but, also for profit from 
increase of market values, for securities rarely remain distinctly 
undervalued for long periods of time. 

Marketability is the facility with which a security can be bought 
or sold. Since it is nearly always possible, however, to buy or sell 
a security of known income-producing quality at some price, the 
concept of marketability has been extended to mean the facility with 
which the security in question can be bought or sold at a reasonable 
price. The best test of reas.onableness in price is the “spread” or 
difference between what the investor can probably get if he tries to 
secure a quick sale and the price he would have to pay to obtain 
additional securities of the same type. Marketability is largely a 
question of the size of the holdings. For the small investor, there 
are innumerable high-grade securities of attractive yield which have 
a “close” market for the small units in which he is interested, but 
there are very few securities which can be bought or sold in very large 
quantities without forcing the price materially upward or downward. 
Quotations for listed securities, and for those unlisted securities in 
which there is sufficient trade to maintain a quotable market, are the 
prices at which small lots—usually one hundred shares in stocks and 
$1,000 in bonds—are changing hands, and may be entirely misleading 
if used as indices of the marketability of large lots. Quotations for 
new securities which are in process of distribution are particularly 
deceptive, because such securities are regularly supported by standing 
bids from the distributing houses at the issue price. This gives the 
market the appearance of being very close and active. Investors who 
buy bonds in reliance on these quotations as an assurance of their 
ability to recover their capital at will are likely to find at a later time 
that the quoted market has disappeared and that the only outlet for 
the securities is through the distributing house. Such houses usually 
do protect their customers by making a market over their own coun¬ 
ters, so that their issues are much more marketable than those of 
corporations which do their own financing or those marketed by 
irresponsible and transient underwriters. 

Marketability is of importance for the investor who is attentive 
to the security market and wishes to shift his funds from one invest¬ 
ment to another as the relative desirability of different issues changes. 
It is also of importance in case all or part of the invested funds are 
likely to be needed for personal support or for strengthening the 
finances of a private business. Marketability, as was noted above, 1 

x See p. 123. 


i86 


RISK AND RISK-BEARING 


is a device to give the investor protection against the risk of being 
unable to recover his funds when he wants them, without creating 
for the borrower a corresponding risk of being called on to repay them 
at an inconvenient time. For most investors, it is highly desirable 
to have some funds in marketable securities, but a waste of money to 
pay for this advantage for all one’s funds. Sometimes the cost is 
negligible, however. The two principal devices for securing market¬ 
ability are, first, the exchanges, and, second, the practice of invest¬ 
ment banks of maintaining a market for securities which they have 
floated. So well developed are these and other marketing agencies 
that the mere fact of a high degree of safety, coupled with attractive 
income yield, is now usually sufficient to insure marketability in the 
case of so many of the investments that no one need pay a high price 
to secure the necessary liquidity in his funds. The two types of 
investment where this is least likely to be true are small real estate 
mortgages and the securities of little-known corporations which have 
been sold without the intervention of an investment banker. In 
these cases, it may readily be true that the risk, as estimated by those 
best informed, is very small, while at the same time the market is so 
restricted by the difficulty of obtaining this information that the 
security will lose much of its attractiveness for those who wish to keep 
their funds mobile. In such cases, the income return is likely to be 
high as compared to the risk of final loss, and the security correspond¬ 
ingly attractive to those who know the facts and do not require 
marketability in their investments. 

The analysis of securities, to determine the degree of risk attendant 
upon their purchase, presents a problem of considerable difficulty, and 
one which differs greatly in character with respect to different types 
of security. So many legal, personal, and technical elements in the 
solution are inaccessible to the individual private investor that he is 
compelled to rely in large part, no matter how careful his own analysis, 
upon the findings of experts. Nevertheless, a knowledge of the ele¬ 
ments of the method to be employed is necessary, if for no other purpose 
than to assist in the choice of counsel. The case is not dissimilar 
to the case for training in law as an aid to the business man. A lay¬ 
man’s training in law cannot serve as a substitute for the services of a 
good lawyer, but it may be very useful as a means of aiding him to 
decide when the lawyer’s services are really needed, and as a guide 
in distinguishing the trustworthy adviser from the charlatan. It is 
true in the investment field, even more than in the furnishing of legal 


THE ANALYSIS OF SECURITIES 


187 


advice, that high respectability and pretentious claims of expertness 
and disinterestedness cannot be taken at face value. A little learning 
is a dangerous thing, but it is quite sufficient to unmask the emptiness 
of the claims of a large proportion of bond salesmen to a standing as 
expert advisers. 

For discussion of methods of analysis, the bulk of investment 
securities may be classified as follows: (a) United States government 
and municipal bonds; ( b ) foreign government bonds; (c) railroad 
bonds and stocks; (< d ) public utility bonds and stocks; ( e ) industrial 
bonds and stocks. 

Concerning the obligations of the United States government, 
those of most of the states, of the federal land banks, and of many of 
the municipalities of the country, the question of safety is hardly 
worth discussion. Conditions under which they would be defaulted 
or become unmarketable are quite thinkable, but they are conditions 
so remote that we have no means of forecasting their approach, and 
no way of selecting alternative employments of capital which are 
free from the same elements of risk. The fluctuations in the value of 
these securities depend on variations in the interest rate at which the 
payments are capitalized, not on factors of risk at all. The choice 
among these investments rests chiefly on considerations of taxation. 
Some are completely exempt from all taxes, others have exemptions 
restricted either to holders of limited quantities or to residents in 
states in which they are issued. These exemptions make them so 
much more valuable than securities not so exempt, to a small group 
of holders, that others frequently cannot buy them at a price where 
they are as attractive as are safe securities without the exemption 
feature. 

In the case of most bonds of political subdivisions of the American 
states, the factor of safety is very high, but more caution is necessary 
in purchasing them than is the case with the issues of the United States 
and of the states themselves. The questions which arise in connec¬ 
tion with them relate themselves, first, to validity; second, to legal 
limitations on the power to incur additional debt; third, to financial 
strength compared with the outstanding debt; and fourth, to character 
of the community. 

The legal questions which arise in connection with municipal bond 
issues are so technical as to make it very difficult and expensive for 
the individual investor to satisfy himself in regard to them; hence, 
except in the case of small- issues which are issued locally, recourse is 


RISK AND RISK-BEARING 


188 

had to the intervention of an investment house which buys and dis¬ 
tributes the issue, giving its customers the benefit of opinion of its 
legal counsel. This method enables all of the issue to be sold to 
scattered investors on the faith of one investigation, and, except in 
the case of the largest buyers, it is the only method which is at all 
practicable. To a certain extent, the same method is applicable to 
other phases of the investigation. The financial middleman takes 
the responsibility of collecting the data relative to financial resources, 
existing debt, limitations on further debt, purposes of the issue, etc., 
and assembles them in a convenient prospectus for the information 
of the investor. It is possible, however, for the investor to check up 
on some of these details, and probably rather better worth while that 
he should do so than is the case with the questions of legality and 
validity. So far as outright misstatement is concerned, the prospectus 
of a reliable investment house is presumed to be trustworthy, for the 
ethics of the business set a high standard of accuracy, but there is 
more likelihood of omission of significant qualifying detail than is the 
case with the opinion of counsel concerning legal requirements sur¬ 
rounding the issue. For example, it is not infrequently the case that 
the amount of debt per capita or per dollar of assessed valuation of a 
given political district is stated without reference to the fact that the 
same population or property is included within the bounds of over¬ 
lapping or coextensive units which have independent debts, or author¬ 
ity to contract them. 

Foreign government bonds have only recently come to occupy a 
large share of the attention of the American investing public. Under 
pre-war conditions, the securities of the leading nations of the world 
shared the distinction of rating as riskless securities. The effect of 
the war has been to destroy the credit of certain nations whose securi¬ 
ties formerly enjoyed this high rating, and to inject an appreciable 
amount of uncertainty into the status of others whose credit is still 
high. It has also had the effect of shaking confidence in the absolute 
soundness of the bonds of countries which were not adversely affected 
by the war, by emphasizing the uncertainty of the political structure 
of modern civilization which underlies the value of the whole body of 
evidences of public debt of most countries whose securities enter the 
investment market. 

In all probability, there is no considerable group of securities 
in existence whose record of payment of the interest and principal 
of their bonded debt is as likely to be unbroken, which yet yield 


THE ANALYSIS OF SECURITIES 


189 


as high a return as the obligations of the neutral and former 
allied nations of Western Europe. Analysis in accordance with the 
usual methods of comparison of indebtedness, financial resources, and 
record of performance of obligations in the past, entitles them to the 
very high rating which they are accorded by professional financial 
rating bodies. Yet the market’s rating is unfavorable, and the reluc¬ 
tance of investors to register, in actual purchases, the high rating which 
paper analysis affords, is not difficult to understand. The major risk 
in the investment of capital in the securities of the nations of Western 
Europe is the hazard of another great war, and this hazard is entirely 
incapable of mathematical estimate either as to the probability of its 
incidence or as to its probable effect upon the foreign bonds of the 
countries engaged in it. It seems highly probable that the course of 
events over the next decade or two will be such as to strengthen the 
credit rating of all the leading powers; and if so, the yields of their 
foreign debt at this time will seem a few years hence to have been 
incredibly high. It does not on the other hand seem impossible 
that international war, or internal disturbance, may reduce the obli¬ 
gations of other powers to the status of the bonds of Germany and 
Russia; the proper bond yield to discount this possibility is a matter 
of conjecture rather than of investment science. 

In the analysis of corporate securities, the same contrast appears 
which we noted in the analysis of municipal issues, between the items 
which the individual investor can learn and discount for himself and 
the items in regard to which he is dependent on the specialized assist¬ 
ance of the investment banker or other financial specialist. There is 
this important difference, however, that, in the case of the industrial 
issues, the legal questions are relatively of less importance, and the 
general economic and financial factors which are accessible to the 
investor for use in forming an independent judgment are more numer¬ 
ous and more important, so that detailed examination of the problems 
which confront him is more likely to be of practical value. This is 
the more important because the services of the financial middleman 
are available chiefly in connection with new issues, while many of the 
issues concerning which the investor has an interest, are old issues 
which are no longer being pushed systematically by any financial 
organization. 

The following outline suggests the most important items which 
should be taken into account in estimating the investment position 
of the securities of industrial corporations: 


RISK AND RISK-BEARING 


190 


ELEMENTS OE STRENGTH IN INDUSTRIAL SECURITIES 

I. Position of the industry 

a) Secular trend: Is the business likely to increase or decrease in 
importance ? 

b ) Cyclical position: How is this line of business affected by the 
coming and going of prosperity ? 

II. Position of the individual firm 

a) Position in the industry 

1. Strength of competition, present and prospective 

2. Record of growth; evidence of progressive policy . 

3. Reputation of firm in the industry 

b ) Financial position 

1. Current position 

2. Financial history 

3. Banking and underwriting connections 

c ) Personnel 

III. Position of the individual securities 

a) Priority of lien; adequacy of security; protective provisions 

b) Market history 

c ) Technical factors: floating supply, market interest, manipulative 
activity, etc. 

The position of the industry is usually susceptible of more adequate 
analysis than is the position of the individual firm. Industries rise 
and decay as do individual firms. The most profitable investments 
have been those which have been made at an earlier stage in the history 
of a new and successful invention. It does not follow however that 
a policy of seeking such opportunities is a profitable policy. For 
every case where fortunes have been made by buying the securities of 
corporations formed to develop new industries, dozens of ventures, 
which at the outset appeared equally promising, have swallowed the 
capital of their projectors without adequate return. The history of 
the telephone, the telegraph, and the condensed-milk industry is 
constantly kept fresh in the minds of investors by promoters of new 
concerns, while the financial failure of liquid air quickly fades from 
memory. Even where new industries have been successful in the end, 
it is frequently true that the original investors have failed of a reward, 
or that the major returns have gone to those who came to the rescue 
of the enterprise when it had passed its initial difficulties but exhausted 
its capital in so doing. 1 

1 Cf. Conyngton, Financing an Enterprise , chaps, xii, xiii. 


THE ANALYSIS OF SECURITIES 


I 9 I 

On the other hand, the fact that an industry has a long and impres¬ 
sive record of profitable operations is not sufficient to make it a desir¬ 
able field for the investment of additional capital, or even for the 
purchase of securities representing investment already made. The 
price at which such securities are obtainable is usually controlled, 
among other things, by the past record of the industry, and if the 
industry has passed its zenith, investments in it are likely to be over¬ 
valued. This is true not only of cases where the market for its output 
is actually dwindling but also of the less obvious cases where the rate 
of growth is falling or is generally overestimated, so that an overbuilt 
condition threatens. 1 

If the growth of an industry has been determined in part by the 
development of a consumers’ fad, as was the case with the bicycle 
industry in the middle nineties and the radio industry in 1922, there 
is no accurate method of forecasting its development. Collapses, 
due to the appearance of a superior technique of production or the 
invention of substitute products of superior efficiency or lower cost, 
are also impossible to foresee. They are among the inherent risks of 
industry, which can readily be seen to be greater in some industries 
than in others, but cannot be eliminated by research. 

The decline in profitableness which results from an overbuilt 
condition, however, can frequently be foreseen. Statistics of con¬ 
sumption of basic commodities for the leading countries are available, 
and the producing capacity of most industries is also a matter of 
approximate knowledge. During a time of prosperity, whether the 
general prosperity which marks the culmination of an upward swing 
of the business cycle or a boom in a specific industry caused by war 
orders, by a consumers’ craze, or by the development of new markets 
for the product, there is always great danger that an overinvestment 
will take place. The result of such a contingency is not merely to 
waste the capital of those investors who come in last or choose the 
least favorable conditions for their investment; it is often to create 
a condition of overcompetition which makes it difficult for any concern 
in the industry to make satisfactory returns on its capital. 

In general, investments in the securities of corporations which 
have monopolistic advantages are the safest, and those in industries 
where competition is keen are the riskiest. Competition has decided 
advantages from the standpoint of protection of the public interest, 
but monopoly has correspondingly great advantages from the stand- 

1 Cf. J. M. Clark, quoted above, pp. 79-81. 


192 


RISK AND RISK-BEARING 


point of investors. This applies not only to those concerns which are 
protected by patents or franchises or by control of limited natural 
resources. Indeed, it is often the case that such corporations are 
singled out as the subjects of attack by legislators and by the agencies 
which shape public opinion to such an extent as greatly to lessen the 
strength of their position. If this is not the case, the price to be paid 
for their securities is likely to discount the strength of their position 
so that the investor secures a safe investment, but one which yields 
a correspondingly low return. Almost as high a degree of safety, with¬ 
out so much danger of attack, and often without the necessity of pay¬ 
ing so high a price for it, is obtainable through investment in securities 
of concerns which, without possessing actual monopoly power, yet 
have attained such a position of leadership, either through early 
start, unusually competent management, high reputation of product, 
or successful advertising, as to render them relatively free from the 
effects of competition. The advantage which such concerns enjoy is 
particularly apparent in periods of liquidation and depresssion. At 
such times, competition in most lines is abnormally keen, so that even 
those concerns which secure a satisfactory volume of orders find it 
impossible to make a good margin of profit, but the concerns which 
are fortunate enough to have a position of monopoly or semi-monopoly, 
though they suffer a decline in the volume of orders received, are able 
to keep prices at a level which insures a satisfactory profit on the busi¬ 
ness actually done. 

Industries differ widely in the extent to which their volume of 
business and their profit margins are affected by the business cycle. 
It is not necessarily true that an industry in which there are violent 
fluctuations of prosperity and depression is for that reason either more 
or less profitable than a steadier industry, but it is necessary to take 
careful account of this factor in appraising the financial record of the 
individual concern for two reasons. In the first place, the securities 
of corporations engaged in lines where the fluctuation is great are to a 
considerable extent valued upon the basis of the immediate outlook, 
rather than upon the average of good and bad times which determines 
their real income-producing power. Hence they are very likely to 
be overvalued in good times and undervalued in bad times, and the 
investors’ decisions should be made with this factor in mind. In the 
second place, many industrial corporations and not a few underwriting 
concerns are not overscrupulous about choosing financial data in 
such a way as to make the best possible showing for the concern. 


THE ANALYSIS OF SECURITIES 


193 


Hence, prospectuses which advertise securities on the basis of the aver¬ 
age earnings for the preceding three or five years, or the balance 
sheet at a given time, should be scrutinized with care to see whether 
they represent the showing during an abnormally favorable period 
of the business cycle. 

The extent to which a given industry is subject to the influence 
of cyclical movements depends chiefly on the character of the product. 
Consumption goods are affected quite differently from producers’ 
goods. Among consumers’ goods, the demand for luxuries fluctuates 
more than that for necessities, but even so-called necessities show 
plainly the effect of changes in income which result from prosperity 
and depression. More important is the classification into goods which 
make up a significant part of the budget and those which are trifling 
in importance from the standpoint of the amount spent by any one 
user. Matches, for instance, show much less evidence of the cycle 
in their market than does meat, though a proportionate reduction in 
the consumption of matches would probably involve much less real 
sacrifice for the community. 

Producers’ goods fluctuate in demand with the demand for the 
product, but this fluctuation is greatly accentuated in certain lines by 
the producers’ practice of specializing in the manufacture of parts and 
supplies for the use of other manufacturers who produce themselves 
enough to supply part of their needs. In case, for instance, a manu¬ 
facturer of automobiles is equipped to produce a certain part in 
sufficient quantity to supply his needs when his plant is running at 
half-capacity, a decline in his business from 100 per cent to 75 per 
cent of capacity will result in a reduction of about 50 per cent in his 
purchases, assuming that he does not produce or purchase for stock, 
and a 50 per cent reduction in the volume of his orders will take him 
out of the market as a buyer entirely. 

Still more important, in many cases, is the question of perisha¬ 
bility of product. If it is possible to store up a product for future use 
or sale at times when scarcity or rising prices are expected, the fluctua¬ 
tions in actual consumption will be greatly exaggerated in the market 
demand for the product. For example, the demand for bread shows 
little effect of the cycle, but that for flour shows it very clearly. 

Another important point is the readiness with which prices of the 
commodity or service sold reflect changes in market conditions. Lines 
in which selling prices are fixed by law or custom have a cycle of pros¬ 
perity inverse to that of most businesses, their costs going up in times of 


194 


RISK AND RISK-BEARING 


prosperity more than their incomes, and vice versa. Gold-mining and 
the manufacture of artificial gas are illustrations. This point is of 
importance not only in connection with the securities of corporations 
engaged in these industries but also in judging the position of industries 
which sell them equipment and supplies. Manufacturers of electrical 
equipment are relieved of part of the effect of the business cycle by 
the fact that their sales to public utilities are likely to increase at times 
when their sales to industrial concerns are at a minimum. 

Analysis of the financial position of industrial corporations always 
involves a large margin of error. —Whereas the facts concerning the 
present condition and outlook for whole industries are in large part 
common knowledge so far as they are available to anyone, the facts 
concerning the position of individual corporations are highly confiden¬ 
tial, and are imparted to the investing public only in so far as the 
management deems it good policy to do so. Many large and appar¬ 
ently prosperous concerns publish no information concerning their 
finances, and this in no way reflects upon their standing. Concerns 
which desire to secure funds from a wide range of investors, however, 
through the sale either of stock or of bonds, are practically compelled 
to give out a certain amount of information, and some firms consider 
it good policy to publish financial statements even though they are 
under no immediate pressure to do so. Of these reports, by far the 
most important, so far as investment analysis is concerned, are the 
balance sheet and the income statement. These are worthy of careful 
study by the prospective investor, first, because the elements of 
strength or weakness do not all lie on the surface of a perfectly 
unbiased report, and, second, because reports are often colored to suit 
the purposes of the management, and evidence of this coloring may 
sometimes be detected, particularly if a series of statements for succes¬ 
sive years is available for purposes of comparison. 1 

The following questions suggest some of the factors which the 
careful investor, or the speculator operating for the long swing, will 
take into consideration in analyzing the reports of industrial 
corporations: 


1 It must not be overlooked that the bias is not always in the direction of 
making the corporation appear more prosperous than it really is. For purposes 
connected with market manipulation, or for the sake of the effect upon competi¬ 
tion, in recent years also on account of income taxation, it is frequently desirable 
to make the prosperity appear less than it actually is. 


THE ANALYSIS OF SECURITIES 


195 


A. QUESTIONS ON THE BALANCE SHEET 

1. At what time was the balance sheet drawn? For instance, does 
it reflect a peculiar seasonal situation? Does it reflect the actual 
position or that which will obtain after a proposed issue of new securi¬ 
ties? The practice of issuing balance sheets “ adjusted to show the 
effect of the present financing,” which was popular in connection with 
the distress flotations of 1920-21, operates frequently to cover up a very 
weak current position. By subtracting the amount of the new issue 
from the fixed liabilities and adding a similar amount to the current 
liabilities, or subtracting it from the cash, an approximation of the 
current position can be obtained. 1 

2. How are the fixed assets valued? This information is not 
always obtainable, but can generally be secured in connection with 
new issues. In analyzing statements of corporations which are not 
in the market to sell securities, some idea of the valuation method can 
sometimes be gotten by comparing the valuation of fixed assets with 
that of other corporations engaged in a similar line of business, or 
checking through a series of statements to see whether the growth has 
corresponded to the growth of other items. Sudden increases in 
value assigned to fixed assets frequently indicate a desire to cover up 
the depletion of surplus through business losses. 

3. Are depreciation reserves adequate , and are the depreciation allow¬ 
ances consistent? Manipulation of the depreciation reserve is a 
favorite method of producing misleading results in the calculation of 
net income. In many cases, however, it is impossible to tell accurately 
whether this has been done, because the only figures given are for 
depreciated value of assets. 

4. Are the figures for good-will reasonable? This item is of less 
importance than it is frequently judged to be. There is a strong 
prejudice in favor of a “clean” balance sheet with no intangible 
assets, but if the good-will item is shown separately so that it is possible 
to see what the tangible assets amount to, the inclusion of a large 
item of good-will offset by a correspondingly large item of sur- 

1 For example, a prospectus of a bond issue, gotten out by a reputable bond 
house early in 1920, emphasized by the use of black-faced type the current ratio 
of 18:1, obtained by applying part of the prospective net return from the bond 
issue against current liabilities and adding the remainder to the cash. The actual 
ratio was apparently about 1:1. In this case, it happened that the sale of the 
bond issue was never completed. 


196 


RISK AND RISK-BEARING 


plus, is an item neither of strength nor of weakness. If there is 
a large good-will item and the surplus is not sufficient to offset it, 
the stock is shown to represent wholly or partially a capitalization 
of actual or anticipated earning power and not an actual investment. 
In the case of a going concern, even this does not of itself indicate a 
weak position. The earnings are the significant item. In the case 
of a new company with no record of earnings, a large item of good-will, 
offset by stock issues, indicates that the stock has no present value, 
and the risks of the enterprise will fall on the prior lien securities, 
which will nevertheless have only a limited claim to the earnings. 

5. Are the figures in the investment account satisfactory ? The 
investment item is frequently difficult of interpretation. If small, it 
may be disregarded, but in the case of a holding company it is impor¬ 
tant to know on what basis the securities of subsidiaries are valued. 
Sometimes advances to subsidiaries which are uncollectible are carried 
as investments, and sometimes the item represents fictitious book 
values of subsidiaries, securities which have no market, and whose 
value to the parent company bears little relation to the figure at which 
they are carried into the balance sheet. Information concerning this 
item is not readily obtainable; in case it is not to be had, large figures 
for investment should be given little weight in evaluating the strength 
of the company. 

6. What is the ratio of quick assets to current liabilities? This 
item is more important in analyses made for use in passing on applica¬ 
tions for short-time credit than it is in investment analysis. Two to 
one has been widely accepted as a normal minimum ratio, though the 
significance of a variation from this ratio is quite different at different 
times of the year and at different stages of the cycle. Wide variations 
from this ratio are not necessarily indicative of abnormally weak or 
strong positions, but there should be some satisfactory explanation 
for them. 

7. Is the inventory account satisfactory ? Excessive inventories are 
a source of weakness in times of falling prices and of strength in times 
of rising prices. It is this fact that makes the current ratio (ratio of 
quick assets to current liabilities) of such different significance at 
different stages of the cycle. The item has very different meaning, 
moreover, in the case of corporations which hold inventories for sale 
from its significance where the inventories are used up in furnishing 
services whose value does not fluctuate with changing values of the 
inventory. 1 

1 See p. 193. 


THE ANALYSIS OF SECURITIES 


197 


8. Is the net working capital adequate? Corporations which show 
a narrow margin of working capital above absolute requirements in 
times of prosperity are apt to be the first to collapse in times of 
adversity. 

9. Does new financing appear to be imminent? This question is 
closely related to the preceding one. It is usually poor policy to buy 
the stock of a corporation just prior to the announcement of new 
financing, particularly in times of liquidation and depression, unless 
the credit of the corporation is very good indeed. 

10. What is the character of the surplus ? Does it seem to represent 
profits available for distribution, profits permanently reinvested, 
premium from stock sales, or capitalization of hopes through inflation 
of the good-will or fixed asset items ? Some corporations habitually 
transfer surplus permanently reinvested to the capital account through 
stock dividends; others allow it to remain in the surplus account. 
From the standpoint of the preferred stockholders and the bond¬ 
holders, the former policy is preferable as it makes it impossible to 
distribute the accumulated surplus to stock-holders through cash 
dividends. 


B. QUESTIONS ON THE INCOME STATEMENT 

i. Is the income ample to cover the requirements? These include 
interest, dividends, sinking funds, amortization of discount, etc., on 
the security under consideration, together with all prior claims. In 
most lines of business, the income in a normal year should cover inter¬ 
est requirements on a given bond three or four times to entitle it to a 
conservative rating. Preferred stocks require a higher margin of 
safety to entitle them to an equally good rating, as they are likely to 
have their lien impaired by the issuance of bonds with a prior lien. 
Even when this is apparently rendered impossible by stipulation in 
the indenture covering the preferred stock, there is always the prob¬ 
ability that bank loans and trade indebtedness will accumulate, and 
these claims always come ahead of the claims of the stock. When 
this has taken place, if the corporation has difficulty in meeting 
maturing claims, the preferred stockholders are likely to be asked to 
sanction a bond issue to refund the indebtedness, and they can gain 
no advantage by refusing. Moreover, in case of reorganisation, it is 
customary to treat preferred stock in much the same way as common, 
no matter how amply its priority has been protected by stipulations 
which appear to make it almost the equivalent of a bond. 


198 


RISK AND RISK-BEARING 


Common stocks should earn twice the dividend, if the dividend 
is capitalized in the selling price at anything like the going rate for safe 
investments. There is much more variability in the ratings of com¬ 
mon stocks, however, for the price discounts all probable future 
increases of earnings, and this factor may justify a price far in excess 
of what the present earnings or dividends would support. 

2. Have inventory losses been carried into the income statement ? 
During the recent period of falling prices, many corporations charged 
their inventory and other extraordinary losses direct to surplus or 
to reserves set up previously, while others charged them to current 
income. Either method is defensible, but in comparing the showing 
made by different corporations it is important that a difference of 
policy in this regard be not overlooked. 

3. Have earnings been manipulated by abnormal charges to reserves? 
Reserves are of two classes: first, the reserves for depreciation, bad 
debts, and similar items, which represent an actual correction of the 
book value of asset items, and, second, proprietary reserves, such as 
“Reserve for Contingencies,” “Reserve for Inventory Shrinkage,” 
“Dividend Reserve,” which are merely ear-marked surpluses. By 
making charges to the first class of reserves unduly small, the earnings 
may be padded to conceal the effects of bad management or mis¬ 
fortune; by making them excessive, or by making charges to the. 
second class of reserves against earnings, instead of against surplus, 
the earnings can be made to appear smaller than they really are. 
Examination of the reserve accounts will often make such manipula¬ 
tion evident. 


C. QUESTIONS ON THE FINANCIAL HISTORY 

1. Has the growth of gross and net earnings kept pace with the growth 
of the industry ? 

2. Has the working capital been increasing with the growth of the 
business? An increase of surplus or of capital accompanied by a 
decrease of working capital means that earnings have been made in 
the form of increased quantity or higher valuation of fixed assets. 
Such absorption of earnings in plant is not necessarily unfavorable, 
especially in a rapidly growing business, but it may mean that a 
showing of profits is being made through charges to betterment of 
what are really repairs, or through excessive valuation of fixed assets. 
It is much easier to verify the bona fide character of earnings accumu¬ 
lated in quick assets than of those which appear in plant gains. More- 


THE ANALYSIS OF SECURITIES 


199 


over, even if the gains so shown are actual, there is indication of danger 
that the business is expanding too rapidly for safety. 

3. Has the dividend policy been liberal or conservative? From the 
standpoint of bondholders and preferred stockholders, a policy of 
dispensing dividends freely to common stockholders is objectionable; 
from the standpoint of the buyer of common stock, the answer is not 
so simple. Excessive liberality indicates a weakness, but the question 
what constitutes excessive liberality depends on such circumstances 
as the variability of the earnings, the necessity of maintaining large 
reserves against inventory and credit losses, the amount of borrowed 
capital used, concerning which no brief general statement is likely to 
be of value. 

D. QUESTIONS ON CORPORATE POLICY AND PERSONNEL 

1. What is the character of the banking connections ? Naturally, the 
fact that a corporation’s securities are underwritten by the leaders in 
the business of handling securities of the type in question is a favorable 
point. The absence of such connections, however, does not condemn 
a security; it merely makes it necessary to seek a reason for their 
absence. Some excellent issues are brought out without the aid of 
underwriters, because they are too small to be attractive to high-grade 
houses; others, because the concerns issuing them feel strong enough 
to dispense with the investment bankers’ support. 

2. Does the management seek publicity for its financial successes? 
As a rule, it is an unfavorable sign if the management seems anxious 
to secure publicity for its large profits. Very profitable enterprises 
are more likely to wish to avoid undue publicity because of its effect 
in stirring up competition and also because it increases public 
pressure for lower prices for their products. However, there are very 
successful firms which pursue a policy opposite to that of the majority, 
making use of their financial success as a means of attracting attention 
to the merits of their products. When the management is unusually 
willing to have its profits advertised, it creates the suspicion that a 
market is being maintained on which insiders may sell out their 
holdings but such suspicion is not always justified. 

3. Have dividends been increased recently more than earnings seem 
to justify ? Or have extra cash dividends and stock dividends been 
granted ? The bearing of this question, from the standpoint of the 
bondholder and the preferred stockholder, has been indicated in con¬ 
nection with other questions. The receipt of dividends is of course 


200 


RISK AND RISK-BEARING 

% 

the only thing that gives value to stocks, so that increases, if there is a 
probability of their being permanent, are favorable. Very large 
distributions, however, are likely to be interpreted as being more favor¬ 
able than they really are. During a period of rapid expansion, when 
large profits are being earned and the volume of business is increasing, 
corporation managers are reluctant to disburse unusually large 
amounts to stockholders for the reason that the funds are at that time 
especially valuable to the business. It is at the end of a period of 
high prosperity that accumulated earnings can best be distributed, and 
extra dividends are therefore an index of past, rather than of prospec¬ 
tive, prosperity. 

Moreover, there are indications that stock dividends, extra divi¬ 
dends, and increases of cash dividends have sometimes been used as a 
cover for the distribution of stock by insiders to the general public. 
The experience of 1907, 1911, 1917, and the early part of 1920, upon 
all of which occasions unusual increases in dividends were accompanied 
for many months by declining stock prices, indicates that the good 
news of dividend increases was regarded by large holders as an oppor¬ 
tunity to dispose of their stocks. 

Railway and public utility securities present an entirely different 
problem. —In the first place, the capitalization of railways and utilities 
is usually more complex than is the financial structure of industrial 
companies. One principal reason for this is that there is less variation 
in the net earnings of railways and utilities. It is therefore possible 
to issue underlying bonds which offer a very high degree of safety, 
since there is slight possibility of such great decline of earnings as 
will imperil them, while at the same time part of the necessary capital 
must be secured through the offer of speculative inducements because 
there is no assurance of sufficient income to pay a return on the entire 
capital. Moreover, in the case of the railroads, there are usually his¬ 
torical reasons for the existence of numerous bonds secured by liens 
on specific parts of the property, and also for numerous strata of 
bonds superimposed upon the same property. Without attempting 
to work out a detailed method of analysis of railway and utility securi¬ 
ties, the following points of difference from the industrials may be 
noted: 

1 . The property account is of even less importance in railway and 
utility statements than it is in industrial statements. —The bulk of the 
property is not salable for any other purpose than that for which it is 
being used, and the separate parts of the property have much less 


THE ANALYSIS OF SECURITIES 


201 


value as separate units than they do as a single property. The 
security of the investor depends almost entirely on the continued 
earning power of the corporation. 

2. The current assets and current liabilities are of much less impor¬ 
tance than in industrial statements .—The inventories are not held for 
sale; the accounts receivable are small; and it is rarely the case that 
sufficient capital is obtained through bank loans to make the problem 
of meeting maturities of short-time obligations a serious one. 

3. Conversely , the proportion of fixed charges to net income is much 
more important than it is in most industrial corporations .—The cost of 
capital is always an important item, and if too large a proportion is 
obtained through securities bearing a fixed charge, some sort of re¬ 
organization to scale down those charges becomes necessary. Fixed 
charges usually play a less important part in industrial failure and 
reorganization. 

4. Relations with public authorities are of greater importance in 
the case of railways and public utilities than in the case of industrials .— 
Typically, the rates charged by utilities are fixed by some public 
authority or are subject to review, and the demand which they serve 
is so inelastic that their income is, to a large extent, determined by 
the rates they are allowed to charge. Hence changes in the attitude 
of legislatures, courts, and of the public are of primary importance. 

5. Railway reports are more uniform and easier of interpretation 
than industrial reports; public utility reports less so .—The uniform 
system of accounting prescribed by the Interstate Commerce Com¬ 
mission makes it possible to secure prompt and intelligible information 
concerning the finances of the railways. The only serious discrepancy 
between one such report and another arises from the item of mainte¬ 
nance. Formerly, there was wide difference of policy between different 
roads as to what should be considered as expense and what charged 
as betterment. Uniformity in this regard has been secured in recent 
years, but there is still a considerable margin of uncertainty in the 
figures for maintenance and consequently in the net earnings, on 
account of the extent to which maintenance can be deferred or 
hastened. 

Public-utility reports are less uniform, and are frequently very 
difficult of interpretation because of the lack of adequate information 
concerning the amounts allowed for depreciation, particularly in the 
accounts of subsidiary companies of large holding companies. The 
same ambiguity occurs in the reports of industrial corporations, but 


202 


RISK AND RISK-BEARING 


it is of more importance in the case of the utilities on account of the 
very large amount of fixed capital employed. 

Finally, it remains to consider the factor which is most important 
of all, but most difficult of access for the small investor—the character 
of the management. Upon the ability and character of the men to 
whom the management of his capital is intrusted, the investor must 
rely for honest and capable service. This factor, however, cannot be 
learned from the perusal of annual reports. Some information con¬ 
cerning the personality and past performance of prominent industrial 
leaders may be gleaned from the financial press, but the reader is 
usually uncertain as to the extent to which the information so obtained 
is inspired by the leader himself, or by those who have a personal inter¬ 
est in promoting his reputation. Something can be learned by 
inquiry through bankers, bond salesmen, and brokers, but much time 
and experience is necessary to sift the wheat from the chaff in current 
gossip concerning men prominent in the world of finance. 

The best index to the character and capacity of an industrial 
leader is the record of the corporations he has led. The man who has 
been for years connected with the management of corporations whose 
record of growth, progressive policy, fair treatment of investors, and 
financial stability is good, comes to command the confidence of the 
business community, and his name lends prestige to weaker or newer 
businesses with which he may later associate himself. Inferences 
drawn from the reputation of men who are associated with the manage¬ 
ment of otherwise doubtful enterprises are by no means infallible, but 
in most cases no better guide is available. 1 

Diversification is a very effective method of reducing risk, so effective, 
indeed, that it may well be said to be the foundation principle of 
investment. No analysis of financial statements and market history 
is adequate to insure safety, unless the investor is content with the 
return obtainable from the highest grade of government bonds. As 
soon as an effort is made to secure a larger return on one’s capital than 
that obtainable through savings bank deposits and purchases of liberty 
bonds and war savings stamps, the factor of risk appears: risk that 
the investor’s analysis may fail through negligence or misunderstand¬ 
ing on his part; risk that financial reports may be deliberately mis- 
• 

1 In relying upon this sort of information, however, care must be taken to avoid 
placing confidence in the reputation of men who are only nominally associated with 
the management, or who, though once active, have ceased to play a dominant 
r61e in the corporation’s affairs. 


THE ANALYSIS OF SECURITIES 


203 


leading; risk that quite unpredictable misfortune may overtake 
borrowers whose position appears to be the strongest. 

Against all these dangers, diversification offers the largest measure 
of protection. The wider the range of investments the less is the 
probability that all or the larger portion will turn out to be weaker than 
they appear to be. This is simply the application of the law of large 
numbers; the elimination of risks through combination. 1 

To obtain the maximum benefit of distribution, it is necessary not 
merely that the number of separate securities or separate borrowers 
represented shall be large; it is equally important that they shall 
represent enterprises exposed, as far as possible, to different hazards. 
•If possible, the diversification should be wide enough so that the 
failure of any one obligor, or of any group exposed to similar hazards, 
will not create serious embarrassment. A properly diversified list will 
contain representatives of all the leading classes of investment securi¬ 
ties; and within each group will contain representatives of as diverse 
geographical, industrial, and commercial conditions as is reasonably 
possible. The inclusion of representatives of all the different standard 
types of security is necessary in order to secure protection against 
the effects of a decline of the investment standing of some one entire 
group, such as happened in the case of the public utilities and also in 
the case of European government securities during the Great War. 
Geographical diversification insures protection against the effects of 
crop failure and reduces the effect of the business cycle. Diversifica¬ 
tion of industries represented also reduces the effect of cyclical changes 
and of the collapse of individual industries. Bonds are in general 
more conservative investments than stocks, but a sprinkling of indus¬ 
trial stocks serves as an offset to the losses incurred by investors in 
times of rapidly rising prices, for dividends on industrial stocks are 
likely to increase at such times, while bond interest remains stationary 
in nominal amount and declines in real purchasing power. 2 

In grouping the securities of railroads or industrial corporations, 
an additional element of safety can be secured by balancing the 
securities of strong competitors against one another, so that a serious 
decline in the income of one, if caused by competition, is likely to be 
offset by a gain on the part of the other. 

1 See chap. ii. 

2 The experience of many colleges and other endowed institutions during 
recent years has emphasized the desirability of balancing the customary heavy 
investments in fixed income securities with a proportion of securities whose income- 
producing capacity will be likely to increase with the level of prices. 


204 


RISK AND RISK-BEARING 


If investments are selected in such a way as to secure actual inde¬ 
pendence of risks, the probability of total loss becomes negligibly 
small with a very short list, but proper diversification is not attained 
till the number of independent risks is large enough so that any 
probable accidental combination of unfortunate developments in 
different fields will not create serious embarrassment. For example, 
if a fund is divided between four securities, and the probability of 
default on any one of them is figured at one chance in twenty, there is 
only one chance in 160,000 that all will fail, assuming that the causes 
of failure are fully independent, but the probability that one or 
another will fail is about three in sixteen. If the investor is dependent 
upon the income of the fund to meet pressing needs, good policy would 
not sanction his running so great a risk of losing one-fourth of his 
principal. Either the fund must be distributed more widely or safer 
securities must be chosen. This illustration points to the reason 
why well-to-do investors often purchase higher-yielding securities 
than are recommended for small buyers. The larger lists permit a 
wider diversification, so that the failure of any one member of the 
group does not eat up all the income from the rest. Of course the 
probability that there will be some losses also increases with the 
number of items included in one’s purchases, but the longer the list 
the closer the actual loss is likely to run to the amount which is antici¬ 
pated and discounted in the purchase price. As was noted in chapter 
vi, investors who do not command a sufficient amount of capital to 
secure diversification in their own investments can obtain it indirectly 
through the mediation of savings banks and other financial institu¬ 
tions. The recent development of the “baby bond” and of stocks of 
low par value has made it possible for the small investor to choose 
from an attractive list of offerings and obtain much more satisfactory 
diversification than was the case a few years ago. The trouble and 
cost of investigating the soundness of securities is as great for the buyer 
of $100 worth as for the buyer of $5,000 worth, however, so that the 
large investor can afford to spread his investments somewhat more 
widely than can the small buyer. 


CHAPTER XI 


SPECULATION IN COMMODITIES 

In a survey of the methods used in speculation in commodities, 
our attention is directed at the outset to a distinction similar to the 
one we observed in our study of the security markets, between the 
listed and the unlisted securities. This is the distinction between 
commodities which are traded in through organized exchanges and 
those which have no such market. In both cases the organized 
market is not essential to speculation and there is, in fact, a con¬ 
siderable speculative interest outside the field which they cover, but 
the speculator’s tasks of executing trades, obtaining information, and 
financing his operations are greatly simplified by the exchange organi¬ 
zation. Because of the concentration of speculative interest in them, 
our attention will be directed primarily to the characteristic features 
of the organized commodity markets and the methods used in operat¬ 
ing through them. 

In its external features and in many of its methods of operation, 
the typical commodity exchange is very similar to the stock-exchange 
organization which was described in a preceding chapter. A com¬ 
modity exchange is an organization of brokers, dealers, and specu¬ 
lators, formed for the purpose of facilitating the business of buying cer¬ 
tain staple commodities and, incidentally, to promote the common 
interests of its members through publicity, legislative, informational, 
and such other services as it may be practicable for it to render. 
The organization of the exchanges, the method of executing trades, 
the ticker system, and most of the rules and practices are very similar 
to those which have been described in connection with stock-exchange 
trading. 

The most distinctive feature of the trade, through the speculative 
produce exchanges in the United States, is the futures contract. The 
peculiarities of this contract explain most of the differences between 
grain or cotton speculation and stock speculation. A futures contract 
may be defined as a contract for the sale of a stipulated amount of a 
specified grade of some commodity at a fixed price at affuture date. 
Typically, it contains the following special features: First, the specific 
provisions of the contract are determined by the rules of the exchange, 


205 


206 


RISK AND RISK-BEARING 


the actual bargain being made in a highly informal way. The rules 
and practices of the exchange are implied in each bargain, in the 
absence of a specification to the contrary. Second, the futures con¬ 
tract is a basis contract , which means that the commodity delivered 
under it may be either of the “contract grade” or of some other grade 
which may be delivered at the seller’s option at a price above or below 
the contract price. The method of determining the differential 
varies in different exchanges. Third, the seller is given the option 
of making delivery at any date between specified limits; in this 
country at any date within a specified calendar month. Fourth, the 
enforcement of the contract is insured by a provision that a specified 
amount known as a margin shall be deposited with some third party 
by each of the contracting parties. These deposits are intended 
to protect the seller against a refusal of the buyer to make good his 
contract in case of a fall in prices, and, conversely, to protect the 
buyer against a default on the seller’s part in case of a rise. Fifth, 
delivery is effected by delivery of warehouse receipts for the com¬ 
modity, which must be stored in a specific place—usually in approved 
warehouses in the city in which the exchange is situated. 

While a futures market is not essential to commodity speculation 
and has other uses besides promoting speculation, such a market is 
extremely convenient for the speculator’s purposes. Its great 
advantage is that until delivery date arrives, the buyer does not have 
to pay for the goods which he has bought, nor does the seller have to 
own them. This tremendously simplifies the financing of commodity 
speculation. The speculator who in October buys wheat for May 
delivery need not worry about paying for it until May comes, and if 
he sells before that time can have the grain delivered direct to his 
buyer by the person from whom he bought, so that he does not have 
to advance any capital except for margin purposes. On the other 
hand, the speculator who believes that wheat is likely to fall in price 
can sell in the fall for May delivery and need not purchase the wheat 
to fulfil his contract until the last day of May, Whenever he buys 
he can have settlement made direct between his buyer and his seller, 
without any responsibility except to keep his margins good and 
settle his losses. 1 

1 Commodity speculation can also be carried on through the use of warehouse 
receipts for commodities in storage, in much the same way that stock speculation 
is carried on through the transfer of certificates, the warehouse receipts being 
loaned for short sales and the buyers paying cash for them. This method was 
used before the general development of the futures market. Under this system 


SPECULATION IN COMMODITIES 


207 


The following are the futures markets in the United States, as 
listed by the Federal Trade Commission: 


Trading in Cereal Futures—Grains Traded in on Each Exchange 

in the United States 


Chicago. 

Wheat 

Corn 

Oats 

Rye 

Barley 

Minneapolis. 

Wheat 


Oats 

Rye 

Barley 

Duluth. 

Wheat 



Rye 

Milwaukee. 

Wheat 

Corn 

Oats 


Omaha. 

Wheat 

Corn 

Oats 



Kansas City. 

Wheat 

Corn 

Oats 



St. Louis. 

Wheat 

Corn 

Oats 



Toledo. 

Wheat 

Corn 

Oats 



Baltimore. 


Corn 




San Francisco. 



Oats 



Chicago Open Board.. 

Wheat 

Corn 

Oats 




There is also at Duluth a futures market for the special variety of wheat 
known as durum. There is similarly a market for kaffir corn (including 
milo maize and feterita) at Kansas City. In addition to the food grains, 
flax futures are traded in at Duluth. Toledo has futures markets for the 
several important kinds of hayseed—clover, alsike, and timothy. The 
New York Produce Exchange has a futures market in cottonseed oil. At 
New York, also, and at New Orleans are important markets in cotton 
futures. Butter and eggs, prior to the entrance of the United States into 
the World War, were traded in through a call for futures on the New York 
Mercantile Exchange, the New York Butter and Eggs Exchange, and the 
Chicago Butter and Egg Board. Provision futures (pork products) are 
traded in at Chicago. * 1 

To this list may be added the futures market in coffee and sugar 
maintained by the New York Coffee Exchange, and the recently 
established market for cottonseed oil on the Chicago Board of Trade. 
Leading futures markets of other countries include a very active 
cotton market in Liverpool, silk and rice markets in Tokyo, and large 
wheat markets in Winnipeg, Rosario, Buenos Aires, and Liverpool. 
A great many other commodities have at one time or another had 
futures markets of more or less importance. 

The qualifications of a commodity which adapt it to future 
trading are: first and most important, that it shall be susceptible of 

the speculative buyer has to meet the cost of storage, insurance, interest, and other 
carrying costs, and commissions are higher than in the futures market, hence the 
method has gone out of use except for commodities not traded in through the 
exchanges. 

1 Report of the Federal Trade Commission on the Grain Trade , V, 31. 































208 


RISK AND RISK-BEARING 


accurate classification into a fairly small number of grades, so that 
buyers may have a definite idea of what they are likely to have 
delivered to them; second, that there shall be a large enough interest 
in the commodity so that would-be buyers can be fairly sure of finding 
sellers at any time, without bidding up the price out of reason, and 
vice versa, that sellers shall be able to find buyers at reasonable 
concessions in price; and third, that the supply of the commodity 
physically available shall under all ordinary conditions be quite 
large. This last qualification is necessary, in order to protect sellers 
against the danger of finding the entire available supply bought up 
and held off the market when they try to obtain the goods to fulfil 
their contracts. 

To illustrate the customs and methods of future trading, the 
wheat market on the Chicago Board of Trade will be described in 
some detail. The Chicago Board of Trade is an incorporated body 
of about i,600 members. As noted above, it provides facilities for 
trading in five grains, in cottonseed oil, and in pork provisions. The 
speculative trade in rye, barley, and cottonseed oil, however, is quite 
negligible in volume, and oats, short ribs, and pork also comprise 
only a small part of the trading. Wheat and corn make up the bulk 
of the grain trade, and lard is the speculative leader in the provisions 
group. 

The management of the Board of Trade is sufficiently similar to 
that of the New York Stock Exchange, described above, to make a 
detailed description unnecessary. In theory, the membership is 
not closed, a contrast to the organization of the New York Stock 
Exchange, which it will be remembered, is limited to 1,100 members. 
In practice, however, no new memberships are created. The market 
price of a seat is usually in the neighborhood of $7,000 to $8,000 
while the fee for entry through the creation of a new membership is 
$25,000. Hence the “open” character of the membership is more a 
theory than a practice. 

The standard futures contract of the Chicago Board of Trade 
provides for trading in units of 5,000 bushels of grain, although 1,000- 
bushel lots of wheat are handled through a special arrangement. 
Contracts are made orally just as is the case in the stock market. 
The small number of commodities compared with the great number of 
stocks handled in the Stock Exchange makes the organization of trad¬ 
ing somewhat simpler. In place of the posts which designate the spots 
for trading in the different securities in the stock exchange, we find 


SPECULATION IN COMMODITIES 


209 


on the floor of the Chicago Board of Trade three pits; one for wheat, 
one for corn and oats, and one for provisions. Trades are made by 
oral bids and offers, and confirmations are exchanged at the close of 
the day’s business. The wheat contract calls for the delivery of 
Number Two red winter wheat at the seller’s option on any date in 
the month specified. Various other grades are deliverable at the 
seller’s option at premiums or discounts. As these differentials are 
fixed in the rules and are changed quite infrequently, one would 
expect that they would frequently get out of line with the actual 
differences in the market values of the various grades. No serious 
dissatisfaction appears to exist with the working of this rule, how¬ 
ever. May, July, September, and December are the only deliveries 
for which any considerable number of contracts are sold. 

Members carry accounts either as principals or as agents for 
outside traders. After a trade has been made, the seller and the 
buyer are both required to post 10 per cent of the amount of the 
transaction with one of certain designated banks, as security for the 
fulfilment of the contract. In case the price of wheat changes mate¬ 
rially before the delivery date, the deposit must be adjusted. If, for 
instance, the market price of a certain contract advances five cents 
per bushel, all members who have that contract bought from others 
may withdraw five cents of their posted margins, and may demand 
that the sellers post additional margin to that amount. The practice 
in regard to calling for these margins depends upon the confidence 
which the traders have in one another’s responsibility. These 
margins posted by the members with banks must not be confused 
with the margins which the broker requires from his customer, when 
dealing as an agent for an outside party. The broker is entitled to 
call a margin from his customer regardless of whether he is himself 
required to post a margin or not. There is no rule regarding the 
size of the margin which may be required from customers. The 
actual practice varies with the activity of the market, the amount 
of confidence the broker has in his customer’s financial responsibility, 
the value of the account to the broker, and the readiness with which 
the customer can be reached in an emergency in order to call on him 
for additional security. 

The fulfilment of all contracts is made by the delivery of ware¬ 
house receipts for grain stored in “regular” warehouses, that is, 
warehouses which have been authorized by the directors of the 
exchange to handle grain for delivery on contracts. In practice, a 


210 


RISK AND RISK-BEARING 


great majority of the trades do not involve an actual delivery of grain 
directly between the parties, although any buyer or seller can obtain 
delivery if he desires. This is true not because the contracts are 
fictitious, but because in most cases the grain is resold before it is 
delivered to the original purchaser. The methods employed in 
handling these transactions have been the subject of a considerable 
amount of uninformed criticism, and an understanding of them is 
fundamental to an understanding of the whole system of future 
trading; hence, they will be described in more detail than would 
otherwise be necessary. 

Suppose that A, a speculator, sells to B, in June, 5,000 bushels 
of “September wheat” at $1.10 a bushel. The next day B sells the 
same amount at $1.11 to C. None of the parties to the transaction 
makes any further trade in this contract before September. It is 
clear that when delivery time arrives the situation will be the same 
as if A had sold direct to C, except that A is entitled to only $1.10 
per bushel when he makes delivery, while C is under contract to 
pay $1.11, the difference constituting B’s profit. If, therefore, A 
makes delivery to C and the prices are adjusted so that each pays and 
receives what he would have gotten if trading had been settled by 
separate deliveries, the result is the same as though separate deliveries 
and payments had been effected, and a great saving in labor results 
both for the traders and for the banks. The courts have uniformly 
held therefore that devices by which A is substituted for B in the 
contract with C are legal, so long as delivery is actually contemplated 
at the time the contract is entered into. For facilitating the adjust¬ 
ment of accounts which wholly or partially offset one another, a clear¬ 
ing house is operated by the management of the Board of Trade. 
This clearing house has nothing to do with the offsetting of the 
accounts, but only provides facilities for settling the balances of pay¬ 
ment due from one member to another. The following methods are 
used in working out the settlement: 1 

1. Direct settlement .—This kind of settlement occurs when each 
of two houses has sold the same contract to the other. Suppose that 
member A has sold to member B 50,000 bushels of September wheat 
during the course of a day’s trading, while B has sold to A 60,000 
bushels of the same option. It is clear that when September arrives 
the trades can be settled by the delivery of 10,000 bushels by B to A; 

1 This account is based chiefly on the Report of the Federal Trade Commission 
on the Grain Trade, Vol. V, chap. v. 


SPECULATION IN COMMODITIES 


211 


hence the remaining account may as well be offset at once, leaving 
on the books only the obligation to deliver and accept the 10,000 
bushels. In this case B is said to be “short” to A 10,000 bushels; 
A to be long from B the same amount. On the next day, A’s sales 
to B may be the larger, so that the balance will be wiped out. 

If all the trades were made at the same price no further adjustment 
would be necessary, but since prices are constantly changing the 
trades offset do not involve an exact offset in the cash payments due; 
the balances due on account of offsets are therefore settled in cash. 
In making these settlements, the clearing house is utilized to effect 
an offset of payments due between the members. The methods used 
are the same in principle as those used in bank clearing houses and in 
the stock clearing house described in chapter viii. 

2. Ring settlement .—A ring is formed when three or more members 
have trades which mutually offset. If A has sold to B, B to C, and 
C to A, and the facts are known, the trades can be canceled and the 
differences paid quite as readily as when there are only two parties 
to the offset. The following diagram illustrates the operation of the 
ring system: 1 

Illustration of the Ring Settlement at Chicago 


(A is assumed to have bought from F at $1.51; F from E at $147; 
E from D at $149; D from C at $1.52; C from B at $145; B from A at 

$1.50*) 



3. Transfer .—The making of rings is entirely voluntary, and not all 
houses co-operate in the somewhat laborious task of comparing books 
in order to locate the rings. Trades which will not “ring out,” either 

1 From the Report of the Federal Trade Commission on the Grain Trade , V, 223. 











212 


RISK AND RISK-BEARING 


because of refusal of members to participate or because the chain 
ends with a house which is accumulating or distributing a large “line,” 
may be disposed of by an arrangement by which the house to whom a 
particular contract was sold substitutes on its books the name of a 
house from which the same quantity was bought by the house which 
is seeking the transfer, and similarly the house from which it was 

bought substitutes the name of the one to which the transferring house 

0 

has sold. Thus if in the case illustrated above the ring broke, say 
because F had sold to G instead of to A and no connection from G to A 
could be traced, any one of the houses except A and G could be released 
from its responsibility by transfer. For example, B might effect an 
arrangement by which A would be substituted for B on C’s books and, 
of course, C on A’s books. 

The principal advantage of these systems of reducing the number 
of open contracts is the immense saving in margins which results. 
So long as contracts remain open each party has the right to protection 
against market fluctuations to the extent of io per cent, so that if 
there were no method of offsetting the trades the amount so tied up 
during the course of a season would grow very burdensome to the 
finances of the commission house. 

At most grain exchanges 1 a more complete system of clearing is 
in use, whereby the necessity of forming rings and effecting transfers 
is eliminated, and each house is responsible only to protect the net 
balance of its open long or short account in each contract. By this 
method each house reports all trades daily to the clearing house, 
which is a distinct corporation, and then substitutes the clearing house 
on its books for the house with which the trade was made. Thus 
each house is “long” or “short” with the clearing house by the net 
amount by which its purchases exceed its sales of the given contract, 
or vice versa, while the clearing house itself is “long” with some houses 
exactly the amount it is “short” to others. Small margins are 
posted by members with the clearing house, and all losses or gains 
from fluctuations in price of the open contracts are settled daily. 
Thus if A has sold 5,000 bushels of May wheat to B and B has sold 
the same amount to C the clearing house will be “short” to C and 
“long” from A. If during the life of the option the market price 
advances two cents, A must pay the clearing house two cents a bushel, 
or $100, and C is entitled to withdraw that amount. By this system 

1 The system here described is frequently referred to as the Minneapolis 
system. 


SPECULATION IN COMMODITIES 


213 


the members are saved a vast amount of labor which is necessary under 
the Chicago system, and the amount of capital tied up in margins is 
greatly reduced. 

It must be emphasized that all these provisions have to do with 
the relations of members of the exchange with one another. The 
customer for whose account a trade is executed has nothing to do with 
the clearing, ringing out, or other process by which one trade open 
on the broker’s books is offset against another. Many brokers notify 
the customer of the name of the member with whom his trade was 
executed, but this does not put the customer into any direct relation¬ 
ship with the other house in question. When a customer has made a 
trade for future delivery of grain, the house through whom he has 
made it is responsible to him to secure delivery or acceptance as the 
case may be. If before delivery month he makes an offsetting trade in 
the same contract through the same broker his responsibility is ended; 
the broker must secure delivery from the member from whom he has 
bought and make delivery to the one to whom he has sold. The cus¬ 
tomer is allowed to withdraw his profits, and required to pay his losses, 
at the time he makes his closing trade, although the actual delivery 
and payment on the contract may not be made by the substituted 
parties for many months. 

This description of the methods used in disposing of contracts 
should make it clear that immense quantities of grain can be bought 
and sold through the exchanges with a very small amount of clerical 
and administrative labor and with very little actual transfer of pos¬ 
session. The process by which the total volume of sales can be made 
thus to exceed by many times the amount of grain actually in exist¬ 
ence is exactly parallel to the process by which the volume of cash 
payments in a given city may in a single day exceed the amount of 
cash held by the banks and their customers. The cash payments so 
largely offset one another that only a small percentage of checks 
involve a transfer of cash from one bank to another. In exactly the 
same way, the system of offset and clearing enables the trade in grain 
to exceed the amount of grain actually held for delivery. In both 
cases, the soundness of the system depends on any individual’s being 
able to get delivery on demand; so long as this can be done a trade in 
grain is no more fictitious because the parties to the trade do not 
handle the wheat than the payment of a debt by check is fictitious 
because the payee does not have the actual cash transferred from the 
bank on which the check is drawn to the one in which he deposited it. 


214 


RISK AND RISK-BEARING 


The methods employed in other commodity futures markets are 
in general very similar to those which have been described in connec¬ 
tion with the Chicago Board of Trade. The most important of the 
smaller grain exchanges are those of Kansas City and Minneapolis. 
There are no records of amounts of grain sold but the Federal Trade 
Commission has prepared estimates based on the volume of clearings. 
For 1916, the most active of recent trading years, the estimates are 
as follows: Chicago, 23.8 billion bushels; Minneapolis, 1.3 billion; 
Kansas City, 1 billion. 

The only other commodity exchange which is of sufficient impor¬ 
tance to warrant attention in a general survey of the speculative 
markets is the New York Cotton Exchange. The methods of operat¬ 
ing through this market are not materially different from those em¬ 
ployed in the grain exchanges. The unit of trading is 100 bales of 
middling cotton (each bale weighing approximately 500 pounds). As 
in the grain markets, the contract is a basis contract, the seller hav¬ 
ing the option of delivering grades above or below middling at a pre¬ 
mium or discount. The system of fixed differences has never worked 
as satisfactorily in the cotton market as it has in grain markets, ap¬ 
parently because the differences in grade are of more importance in 
determining the commercial value of the commodity, and because 
varying weather conditions give rise to very wide differences in the 
proportion of different grades produced in different years. Prior to 
the passage of the United States Cotton Futures Act, the discounts 
and premiums were fixed by a committee; at present they are fixed 
by the Secretary of Agriculture on the basis of the premiums and 
discounts actually prevailing in a large number of selected markets 
for cash cotton. 

Let us now turn our attention from the technical organization 
and procedure of the exchange to the speculator’s methods of seeking 
profit through them. Except in the sensitiveness of the market to 
minor influences making for change, the ease and rapidity with which 
trades can be effected, and the small amount of capital needed to 
control comparatively large units of the commodity traded in, specu¬ 
lation in grain or cotton through the futures markets, differs little 
from speculation in commodities which are bought and sold by the 
ordinary channels of trade. In all forms of speculation the only way 
in which the operator can reasonably expect to secure a profit is 
through some sort of differential advantage over the market as a 
whole, an advantage which may arise either from special training, 


SPECULATION IN COMMODITIES 


4 


215 


unusual ability to judge the trend of the market, or from access to 
special sources of information not available to the general public. 
Few persons, without special knowledge of the businesses in which the 
commodities are used, suppose that they can, as a long run result, 
make profits by speculating in such commodities as lumber, iron, wool, 
or silk, though these commodities have active markets in which there 
are unlimited opportunities for profit for those who are able to fore¬ 
cast them. But thousands of people who would never consider the 
advisability of buying a few thousand dollars worth of any of these 
staples, chiefly on credit, and holding them for a rise, do habitually 
or occasionally match their skill against the market for speculative 
grains and cotton. 

The reason for this disposition is not to be found in any greater 
facility for forecasting the trend of the market in the case of the or¬ 
ganized than in the unorganized markets. The most important dif¬ 
ference is this, that in an organized futures market the commodity 
and the methods of buying and selling it are so standardized that it 
is possible for an individual to buy and sell without taking the trouble 
to learn the technique of judging qualities, the methods of handling 
and storing, the trade customs, and other details which are necessary 
for buying and selling through the unorganized markets. Add to 
this the facts that the amount of capital required is very small, and 
that the markets are so sensitive that profits or losses can be realized 
very quickly, and it is easy to see why organized markets attract a 
following of speculators who are affiliated with the trade in the commod¬ 
ity in no other way. The cotton market has always been particularly 
popular for this purpose in eastern and southern circles and the wheat 
market in the Middle West, though the violence of fluctuation of 
prices during the war and the closing of the wheat pit during the period 
of federal control caused a transfer of interest to the corn market, 
and the wheat market has not fully recovered its following. 

What then are the methods employed by speculators in these 
markets, and what is the probability of success in using those methods ? 
In the first place, it is certain that the ease with which trades can be 
executed in the organized markets does not of itself imply that it is 
any easier to form an intelligent judgment of the probable course of 
prices there than in any other markets. The market price, whatever 
it is, represents the balance of judgment of the trade, both speculative 
and non-speculative, as to the figure at which demand and supply 
will, during the next year or year and a half, be approximately equal. 


2 l6 


RISK AND RISK-BEARING 


Analysis of the conditions of demand and supply is a special problem 
for each commodity, and is the same kind of problem in an organized 
market that it is in an unorganized market. As in all other kinds 
of speculation the average result for the whole group of speculators 
is always a loss, for the commissions and other expenses are running 
against the public just as the percentage in favor of the house runs 
against the public in a gambling hell; the minority who succeed do so 
because their information or their judgment is better than that of the 
market as a whole. The first question which the prospective specu¬ 
lator should ask himself, therefore, is, what advantage have I over 
the average man who trades in this market? If he has no definite 
advantage, the probability is that his chances are below average, for he 
is trading in a market where there are many men with life-long train¬ 
ing in studying market conditions and with access to the resources of 
large organizations for compiling crop reports and trade reports which 
enable them to anticipate to some extent the reports on which the out¬ 
side speculator, the average man, must rely. 

This advantage of the professional must not be exaggerated, how¬ 
ever. The saving feature of the situation, from the standpoint of 
the average speculator, is that his colossal ignorance of the factors 
which he needs to understand in order to forecast the trend of the 
prices is shared to a large extent by those who are not outsiders. For 
though it is clear that the judgment of a man of average intelligence 
who knows nothing of the grain trade is not likely to be of much value 
in forecasting the course of grain prices, the converse is not true. A 
man may be an excellent judge of the qualities of grain or cotton, or 
be expert in transportation, in storage, in bargaining with country 
sellers, or in a dozen other ways in which technical proficiency appears 
among those who make their living in the trade, and yet he may have 
no opinion worth quoting in regard to the probable future trend of 
prices. The market is too big to be judged on the basis of the facts 
which come to the attention of any man in the course of his daily 
routine unless his work involves constant study of the larger factors 
which determine the price outlook. And there are large “unknowns” 
for the most careful forecaster. In most years by far the most impor¬ 
tant factor in making and breaking prices in the grain and cotton 
markets is the crop outlook. Conditions of demand are relatively 
stable, though there is more elasticity in the demand for these so-called 
necessities than is generally supposed. 1 

1 For evidence of this, cf. statistics of consumption in Report of the Joint Com¬ 
mission of Agricultural Inquiry , Part I, chap. viii. 


SPECULATION IN COMMODITIES 


217 


Conditions of supply are extremely unstable, on the other hand, 
so that the speculative public necessarily takes demand more or less 
for granted and concentrates its attention on supply. This does not 
mean that changes in the conditions affecting demand are less influ¬ 
ential than supply conditions in determining the price at which the 
year’s supply will move into consumption; it simply means that 
supply conditions are discounted in the price long before they actually 
materialize, while demand conditions are reflected in prices rather at 
the time they actually occur. For a large part of the year, moreover, 
the most important element in the supply problem, the future course 
of weather conditions, is known to no man. The same thing is true, 
as a rule, of the amount of acreage which will be planted to the next 
year’s crop and of many of the factors of demand. Another large 
part of the necessary data for judgment consists of the statistics of 
visible supply, grain in farmers’ hands, crop conditions, etc., which 
are collected by government bureaus or by private crop reporting 
and statistical agencies, and are available to the general public. This 
is the great argument in favor of speculation in the grain and cotton 
markets for the average man as contrasted with the stock market. 
No one has “inside information” concerning the weather conditions 
next month or the crop conditions of last year. The factors which 
are known to all and the factors which are known to no one are so 
important that the factors which are known to only a few constitute 
a less crushing handicap against the outsider and give him something 
nearer an even chance to save his money than he has in the stock 
market. But the odds are against him in either place. 

The methods of studying the factors making for advance or 
decline of prices in a commodity market admit of no such precise 
analysis as was attempted in our discussion of the technique of invest¬ 
ment and speculative operations in the security markets. To a large 
extent, each successive price situation presents a new problem. In 
general, the factors that are known are very quickly discounted in the 
price, but the facts essential to a complete solution are so imperfectly 
known that there is a wide margin of variation between the futures 
price for any distant month and the prices actually realized when 
that month arrives. In other words, the trade keeps itself well 
informed on the situation, at least the supply side of the situation, 
at any given time, but the situation is so frequently changed by the 
appearance of new and unpredictable conditions that futures prices 
only imperfectly forecast the prices that will be charged in the future. 


2 l8 


RISK AND RISK-BEARING 


The margin of error in the calculations of the market, as a whole, being 
so large, it is not strange that it is wide in the calculations of any 
individual operator. 

Besides the general common-sense method of studying the whole 
situation by the use of current statistics and the history of markets 
in the past, a number of special methods which seek to isolate single 
factors and predict relatively temporary price conditions on the basis 
of these conditions, may be mentioned. 

Calendar-trading is probably more prevalent than it is in the stock 
market, 1 and seems rather less irrational in grain or cotton than in 
stocks. No careful study of seasonal tendencies in the futures 
markets seems to have been made, however. 2 

Weather map-reading is an effort to forecast each day’s market by 
study of the daily report furnished by the Weather Bureau, which 
shows the weather conditions for all parts of the country up to 7:00 
a.m. of each day, before the opening of that day’s market. The under¬ 
lying theory of the map-reader is that a change in weather which will 
directly affect the crop prospects in any section is likely to be reflected 
immediately in buying or selling orders from that section, which may 
be discounted by prompt action based on the weather report itself. 
The author has no data from which a conclusion can be drawn con¬ 
cerning the degree of success attainable by this method of operation; 
it seems quite possible that so long as the number of map-readers is 
small the method may give satisfactory results. A general adoption 
of the method of study would change the problem to that of making a 
forecast on the part of each map-reader of what the other map-readers 
are likely to do. 

Pit-scalping is trading on the floor of the exchange for small fluc¬ 
tuations, largely those anticipated on account of situations arising on 
the floor itself; it is very similar to the similar type of trading referred 
to in connection with the stock market. 

Tailing on is trading on gossip, tips, or direct information con¬ 
cerning the market position of leaders in the trade. This is apparently 
the least promising method of all, but it has a remarkable number of 
adherents, if one may judge from the amount of attention given in 
the market gossip to the doings of prominent traders. 

1 See p. 164. 

2 Tentative studies made under the author’s direction indicate that there are 
probably some seasonal tendencies in futures prices, though they are not at all 
comparable in scope or regularity to those in the cash grain markets. 


SPECULATION IN COMMODITIES 


219 


Spreading is one of the most highly specialized types of speculation. 
This consists in selling one contract and buying another, so that the 
profit or loss will consist in a change in the spread between the two 
prices. For example, a trader may buy December wheat in Kansas 
City and sell the same amount of December wheat through the same 
commission house in Chicago. The two trades do not cancel one 
another; each must be closed out later by a separate transaction. But 
a market change, due to most causes, will affect one as much as it 
will the other, and will afford neither a profit nor a loss. The spreader 
speculates only on the factors which will affect one price more than 
the other, such as an interruption of traffic on account of a car shortage, 
or crop damage in the north occurring after the southern wheat has 
passed its critical point. The range of possible variation in the spread 
is smaller than in the prices taken separately; hence the commission 
house can safely require much smaller margins than would be required 
on either trade alone. For this reason the trader can operate in large 
units, thereby securing a compensation for the narrowing of the pos¬ 
sible profit per bushel. 

In like manner, one may buy December and sell May futures in 
the same market, the speculation in this case involving the premium 
or discount on the one contract compared with the other. Or, one 
commodity may be “spread” against another commodity, as when 
corn futures are bought and oats futures sold at the same time. Most 
price changes in the corn market are accompanied by similar, though 
less extensive, movements in the oats market; if a trader foresees a 
rise in corn prices which will not affect oats, he buys the corn and pro¬ 
tects himself by the short sale of oats against changes due to general 
conditions affecting both. Or the spreader may be simply a calendar- 
trader, who has noticed that the spread has moved in the same direc¬ 
tion at the same period in several successive years. 1 

Since commissions on spreading trades are double those on single 
trades while the probable profit per bushel in the event of a successful 
forecast is much smaller, the commission charges are a heavy handi¬ 
cap against the spreader. For this reason such transactions are 
chiefly those of exchange members, who either execute their own 
trades or pay reduced commissions. 

Unorganized speculation is in large part a subsidiary feature of 
other forms of business enterprise. A speculative element is present 

1 In the cotton market, spreads between different markets are referred to as 
straddles; in the grain trade, the latter term is frequently applied to trades in 
which one month’s contract is bought and another month sold short against it. 


220 


RISK AND RISK-BEARING 

I 

in all lines of business where goods must be held for resale, unless the 
risk can be eliminated by hedging or by “contracting out.” Hedging 
will be discussed in chapter xii; contracting out was discussed in 
chapter iv. In connection with the latter discussion, attention was 
called (p. 61) to the possibility of keeping price risk at a minimum 
by carrying small inventories and balancing advance sales against 
purchases. 

Business men who believe themselves able to prognosticate price 
changes frequently pursue the opposite course to that just indicated, 
increasing inventories when they believe prices are about to advance 
and cutting them down in anticipation of falling prices. To what¬ 
ever extent this policy is practiced, the business assumes the char¬ 
acter of a speculation on price changes, and all that has been said 
concerning the difficulty of profiting consistently through any sort 
of speculation applies to it in full. Wherever success depends on skill 
in forecasting the course of a market it resolves itself into a problem 
of being more skilful or more fortunate than the group whose composite 
judgment makes the level of prices what it is, and speculation in inven¬ 
tory, except that it is not so rapid, is quite as risky as speculation in 
futures. 

Of the specific types of unorganized speculation, only one need 
be given special attention—the trade in land. For many generations 
this has been the favorite American speculation, and its risks are still 
generally supposed to be less than is the case with any other form of 
speculative enterprise. As with other lines of unorganized specula¬ 
tion, land speculation is largely a side issue to other lines of business, 
in this case chiefly agriculture and building, though there is also a 
considerable volume of speculative buying and selling by individuals 
who have no business need to become land-owners. 

As compared with the organized markets described above, land 
speculation presents the following peculiarities: 

i. There is no 11 short side.” In any epoch of land speculation, 
the bulls, therefore, have full control so long as their enthusiasm and 
capital suffice to support and advance the market. Those who believe 
land is going higher, buy; those who believe it is going lower, except 
as they happen to be owners of land which they can sell out, have no 
influence on the situation. Hence, in land booms, prices rise more 
sharply than is likely to be the case in almost any other form of specu¬ 
lation. On the other hand, when prices once turn downward there 


SPECULATION IN COMMODITIES 


221 


are no “shorts” who must come into the market as buyers sooner 
or later, and the lack of this kind of buying makes the collapse more 
complete and sudden than is likely to be the case after the completion 
of a boom in an organized market. 

2. The turnover is relatively slow. Whereas the grain speculator 
can enter into a trade, or close it out, on a minute’s notice, real estate 
often must be held a long time till a buyer appears. 

3. Prices are relatively steady . Except in occasional booms, 
there are few fluctuations, and prices generally show an upward trend 
from year to year. The apparent steadiness, however, is less signif¬ 
icant than it appears, as it is largely due to the slowness of turnover 
previously referred to. Speculative buyers of real estate expect to 
have to hold their properties a considerable length of time; hence are 
not apt to be caught in positions where they must sell quickly at any 
price. Nominal prices remain steady at times when few or no sales 
are occurring, and when a real market could be established only by 
drastic reductions in prices. 

4. Real estate speculation requires proportionately more capital than 
does organized speculation. Whereas stocks and futures can be bought 
and sold on margins of 10 per cent or less, the buyer of real estate must 
usually be prepared to advance at least one-third the purchase price. 
Hence proportionate changes in price mean proportionately smaller 
profits and losses. This factor, together with those referred to in the 
two preceding paragraphs (slow turnover and steady prices), accounts 
for the somewhat smaller proportion of speedy failures among those 
who dabble in real estate speculation as compared with stock specu¬ 
lation or the trade in grain futures. 

5. Individual judgment of qualities of land and individual skill in 
bargaining play a large part in determining success. In an organized 
market, anyone may know at a glance at what price his commodity 
is selling and may confidently expect to buy or sell at practically the 
same price as anyone else would. In the land market, no two units 
are alike; trades are infrequent; the prices actually paid are often 
not made public. Hence there is an opportunity for a good judge of 
values to profit by trading with poorer judges, quite apart from changes 
in the level of prices of other land in the same vicinity. For the same 
reason the element of skill in “dickering” often makes the difference 
between a profit and a loss. 

6. Profits are very generally overestimated. When land is used for 
agricultural purposes by the owner during the life of his speculation, 


222 


RISK AND RISK-BEARING 


or is rented, a nominal profit on resale often represents a real loss if 
account is taken of the fact that the property has failed to yield a fair 
return on the original investment during the time it was held. Agri¬ 
cultural land in the eastern corn belt before the war generally returned 
less than 3 per cent on its sale value, if rented, or if worked by the 
owner with proper allowance for the value of his own time. In most 
localities this situation was not greatly changed by the war boom, 
as land prices and rents and prices of farm products all advanced, 
leaving the net return on the sale price more irregular than before, 
but probably on the average still less than 3 per cent. In such cases 
the excess of the selling price over the figure on which a fair return 
can be earned represents a capitalization of anticipated future returns, 
either in increased direct yield or in the price secured on resale. In 
many cases apparently high prices paid for land have in fact been 
justified by the appearance of the anticipated increases, yet the profit 
on resale has no more than compensated for the loss of interest during 
the years the property was held. 

In the case of urban land held vacant for resale, the point just 
made is still more pertinent. Apart from considerations of taxation, 
land must double in value every twelve years to yield on resale a 
return of 6 per cent on the investment. Urban lands held out of use 
for speculative purposes apparently do not, on the average, increase 
in value at as great a rate as that, and 6 per cent is certainly a low 
return for a speculative transaction. Some individual pieces of land 
improve much more rapidly, and many fail to gain for years at a time. 
In other words, the “unearned increment” is not something which 
accrues automatically as a result of investment in land, but is like 
any other speculative gain, a differential. Such a differential gain 
may be obtained by superior shrewdness in forecasting the lines along 
which a city will develop, by “inside information” concerning the 
plans of municipal governments, corporations, and individuals, or by 
sheer good luck. Its existence in any case, however, is always a result 
of uncertainty, for just as in every other case where future income 
is capitalized, as soon as an increase in the value at a known future 
date becomes certain it is immediately reflected in the present price, 
and the income no longer represents more than pure interest on the 
selling price. 1 

1 The social interest in the activities of the land speculator is discussed below, 
chap, xviii. 


CHAPTER XII 


HEDGING 

Among the institutions which have been developed to aid the busi¬ 
ness man in avoiding the risks incident to our roundabout time-con¬ 
suming methods of production and distribution, one of the most inter¬ 
esting is the system of shifting the risks of price changes, which is made 
possible through the use of the futures markets for “ hedging ” purposes. 

A hedging transaction may be defined as a coincident purchase and 
sale in two markets, which are expected to behave in such a way that 
any loss realized in one may be offset by an equivalent gain in the other. 

As applied in the grain and cotton futures market, the term 
“hedging” refers to one of two types of transactions. The first, the 
hedging sale, arises when a country grain dealer, a terminal buyer, a 
miller, or an exporter buys grain in the cash market and sells futures 
contracts of an equivalent amount, as protection against a fall in price ' 
during the time that the grain is in his possession. The second, the ^ 
hedge purchase, arises when a manufacturer has sold his product 
ahead at a fixed price and l^iys futures to protect himself against an 
advance in the price of raw material. The idea is that if the price of 
cash grain declines a similar decline will probably occur in the futures 
market, and the loss realized on the one transaction will be offset by a 
gain realized on the other. It goes without saying that such a pro¬ 
tection cannot be obtained without giving up the chances of a profit 
from a price fluctuation in the opposite direction. Since the hedging 
transaction involves some costs for commissions, taxes, interest on 
margins, etc., it is clear that the average result of a long series of such 
trades should normally be a slight loss, but this loss is regarded as a 
premium paid for insurance against the risk of such heavy losses in an 
unfavorable season, as would disrupt the business and prevent its 
continuance through the long run, in which gains and losses from 
price changes could be expected to balance. 

The question may arise, why any individual would engage in trans¬ 
actions of such a character that the chances of loss and the chances of 
gain offset one another. The answer is that in changing grain from 
country points to terminal markets, in milling, in jobbing flour, and 
in other operations incident to the production and distribution of 


v 


223 


224 


RISK AND RISK-BEARING 


grain production, the trade or manufacturing profit can be expected 
under ordinary conditions of competition without reference to any 
gain or loss from price changes. The hedge enables the operator to 
make his price and regulate his business on the basis of his ordinary 
trade profit, without the possibilities of speculative loss or gain which 
arises from the instability of prices. It is impossible to carry on such 
operations as these without owning grain or its products through 
a certain period of time, but the hedge enables the operator to isolate 
the ordinary risks of competition from the special risks, which arise 
from the instability of prices of the commodities in which he is 
dealing. 

Several advantages result from such a separation. For one thing, 
the amount of credit which the grain or other operator can secure is 
much greater. This is true because the protection afforded a bank by 
the use of warehouse receipts for grain as collateral is much stronger, 
in case the owner is protected against loss by hedging contracts. The 
principle is the same as that involved in the custom by which the 
mortgagors are required to keep property insured for the benefit of 
mortgagees. In the second place, the use of the hedging contract 
makes it possible to do business on a much smaller margin of profit. 
Where hedging contracts are not available, commodities must be 
handled on a wide enough margin to compensate for the risk of adverse 
price changes. When the protection of the hedging contract is avail¬ 
able, competition ordinarily brings about a narrowing of the profit 
margin in accordance with the reduced amount of risk. This is of no 
financial advantage to the grain dealers as a class, but makes it 
possible for consumers to receive the benefit of lowered prices, or grain 
producers to receive the benefit of higher prices, or for both these 
things to take place, and it also makes the grain dealers’ business less 
speculative. 

It is clear that the gains from the practice of hedging are entirely 
due to the reduction of uncertainty, and not to any reduction in the 
probability of the unfavorable contingency against which protection 
is sought. Whenever a man saves himself from loss by hedging 
through the futures market, someone has to lose to keep him even. The 
question therefore arises whether the total amount saved by hedgers 
as a group on transactions, where they would otherwise incur loss, is 
greater or smaller than the profits they lose in cases where the market 
moves in their favor. The theory generally accepted among econo¬ 
mists is that the speculators who buy and sell hedges to grain dealers, 
millers, and other tradesmen are specialists in the art of discounting 




HEDGING 225 

the future, more expert than those with whom they are dealing, and 
that hedgers as a class, therefore, lose something in the long run to 
the speculators as a class. This loss constitutes the compensation 
of the speculators for the service of reducing trade risk, and from the 
standpoint of the grain trader, should be figured like his commissions, 
as a premium paid for insurance against risks too great to be borne. 

No statistics bearing on this question are available, but it does 
not seem probable that, as a matter of fact, speculators are more expert 
than the dealers with whom they trade. Grain dealers, millers, and 
others who habitually hedge probably stay in business much longer on 
the average than do speculators, and, therefore, accumulate more 
experience. The speculative group includes a certain number of 
professional large-scale operators who do succeed in staying in business 
year after year, and presumably are making satisfactory profits, but 
these are the survivors of a large number whose financial strength is 
exhausted, or whose taste for speculation is satisfied before they attain 
the dignity of professionals. A few speculators make very large prof¬ 
its, but in all probability the business of furnishing hedging contracts 
belongs in the list of services which, as a whole, are rendered for society 
without compensation . 1 Another point which is frequently over¬ 
looked in the discussing of hedging is the question to what extent 
hedging contracts and practice furnish protection against price changes. 
The following selection summarizes the situation in this regard: 

It has been the common custom in works dealing with market 
risks and their elimination to mention hedging contracts as one of 
the most effective social devices for reducing and transferring risk. 
There is in these discussions usually the implication, if not the definite 
statement, that hedging contracts, wherever they can be used at all, 
can be expected to give a complete protection to the user against 
the risk of adverse price changes . 2 Such conclusions concerning 
hedging transactions, as they are carried on in the ordinary course 
of business through the futures markets, are not at all justified. They 
arise from an inadequate comprehension of the nature of a hedging 

1 See above p. 38. 

2 For example: “Whatever it (the milling company which sells hedges) 
gains or loses on the original purchase of cash wheat will be exactly offset by an 
equal loss or gain on the future sale.” F. M. Taylor, Principles of Economics , 
p. 294. “A person who is neither long nor short is running no risk; he is hedged.” 
J. E. Boyle, Speculation and the Chicago Board of Trade , p. 34. “If wheat prices 
have risen he loses on his wheat ‘deal’ but this loss is offset by the corresponding 
rise in flour.” Marshall and Lyon, Our Economic Organization , p. 382. 


226 


RISK AND RISK-BEARING 


contract or from an incomplete understanding of the relations of the 
two markets which are essential to the hedging process. 

To see clearly the possibilities and limitations of hedging con¬ 
tracts on organized produce markets it is necessary to understand 
first what a hedging contract is. The essence of a hedging contract 
is a coincident purchase and sale in two markets which are expected 
to behave in such a way that any loss realized in one will be offset by 
an equivalent gain in the other. If such behavior follows a perfect 
hedge has been effected. The commonest type of hedging transaction 
is the purchase and sale of the same amount of the same commodity 
in the spot and in the futures markets. Frequently, however, the 
trades are in different commodities, as when cottonseed oil is hedged 
in the lard market or flour in the wheat market . 1 

The spot and the futures markets are separate markets. The futures 
market is highly centralized and highly competitive. All futures 
transactions are made in a dozen exchanges, where buying and selling 
orders converge from all over the world. The “spot market,” on the 
other hand, if it can be spoken of as a market at all, is highly decen¬ 
tralized, frequently only partially competitive, and much less respon¬ 
sive to minor forces making for change. Spot trades which it is desir¬ 
able to hedge take place in Gopher Prairie as well as on the floor of 
the Minneapolis Chamber of Commerce. The exporter in Baltimore 
and the miller in Painted Post may be as anxious to hedge purchases 
or sales as is the terminal elevator operator who buys on the floor of the 
Chicago Board of Trade. In speaking of the spot market we may be 
talking about the market in any one of many places. Whereas an 
almost perfect system of communication has made the futures markets 
practically a unit, the separate spot markets are at best only partially 
merged into one. 

Any divergence from the anticipated relationship of the prices in the 
two markets results in an imperfect hedge. The possibility of imper¬ 
fection in the protection offered by hedging trades has been recognized 
by some few writers, but through all the literature of marketing there 
runs the assumption that such variations as make the protection 

1 The distinction drawn here is somewhat artificial, as it rarely happens that 
the commodities bought and sold in the spot and futures markets respectively are 
actually identical. Only specific “contract grades” are sold through the futures 
market, and these are not likely to be the exact equivalent of the spot purchases 
which are being hedged. The imperfect character of the protection offered by 
hedging sales in the case of “off grades” is indicated in J. E. Boyle, op. cit., 

pp. 171-75- 


HEDGING 


227 


inadequate are much more abnormal and infrequent than is actually 
the case . 1 

THE ASSUMPTION OE A NORMAL SPREAD 

The failure to appreciate the varying relationship between spot 
and future prices and the resulting erroneous notions concerning 
hedging have centered about the idea of a “normal spread/’ that is, a 
relationship between spot and future prices which is believed 
to show itself with a high degree of regularity. It is obvious 
that if any definite spread between the spot and the futures price 
does appear with great frequency and permanence the hedger is 
relatively safe in assuming that the two prices will fluctuate in uni¬ 
son, and may place his hedge with the expectation of correspond¬ 
ingly complete protection from adverse changes in price. The nor¬ 
mal spread has been assumed, however, without a careful analysis 
of the assumptions that would be necessary to make it a useful con¬ 
cept. A presentation of the assumptions which are necessary to give 
meaning to the idea will show the fallacy of the notion of complete 
insurance against price changes and at the same time furnish a back¬ 
ground against which the actual happenings and the resultant possi¬ 
bilities of avoiding market risk by hedging may be shown more clearly. 

Coincident fluctuations in any two markets can be expected only 
under one of two sets of circumstances. In the first place, the two 
markets might conceivably remain in line with one another because 
both were controlled by the same forces, or second, prices in one market 
might exercise a controlling influence over prices in the other. In 
practice neither of these things ever happens completely in connection 
with the spot and futures markets of the produce trades. To show 
what does happen, it is necessary first to consider the hypothetical 
conditions under which a perfect hedge could be effected; second, 
to analyze the ways in which the actual marketing situation diverges 

1 For example: “There is every reason to believe that if the price of cash 
wheat rises 10 cents a bushel the September option will also have a rise of 10 cents, 
or approximately that amount.” S. S. Huebner, “The Functions of Produce 
Exchanges,” Annals of the American Academy of Political and Social Science , 
XXXVIII (1911), 343. Fred M. Clark {Principles of Marketing , pp. 370-72) 
recognizes the possibility of a situation in which futures contracts do not offer a 
complete hedge, but seems to regard this situation as highly exceptional. L. D. 
H. Weld {Marketing of Farm Products , p. 345) refers to the failure of hedges to 
offer complete protection on account of the tendency of futures and cash prices to 
draw together as delivery day approaches. When futures contracts are selling 
above cash grain this is a source of gain to sellers of hedges against grain in storage 
or in process of manufacture. For its effect on buyers of hedges against forward 
sales of flour, cf. below, p. 256. 


228 


RISK AND RISK-BEARING 


from these hypothetical conditions; and third, to survey the statisti¬ 
cal evidence concerning the frequency of occurrence of the conditions 
under which a perfect hedge can be secured. The wheat trade furnishes 
a convenient case for both the assumed and the actual illustrations. 

A SUPPOSITITIOUS SITUATION 

f 

Let us begin our discussion by considering a highly artificial and 
simplified situation in which there would be a definite normal relation¬ 
ship between the prices of wheat for immediate delivery and for deliv¬ 
ery at any specified future date. We shall assume: 

1. That there is no carry over; that is, the last bushel of the old crop 
has gone out of the market at the end of the crop year, say on June 30. 

2. That the entire new crop of the world has “come in” at one 
time, July 1, and is accessible. In practice this would doubtless have 
to mean that a very large portion of it had reached central markets 
where it could be retained as a visible supply, and there would have to 
be no doubt that the balance of it could be made available without 
delay when wanted for consumption. 

3. That no additional wheat could possibly reach the market 
until July 1 of the following year. 

4. That costs of storing grain do not change during the year. 

5. That everyone who is interested in the wheat trade has full 
information concerning the available supply. 

6. That everyone in the wheat trade has complete information 
concerning the fact that wheat is to be consumed uniformly through¬ 
out the year and at such a rate as exactly to exhaust the supply on 
June 30. 

7. That everyone concerned can be counted on to act with pecu¬ 
niary rationality. 1 

With these conditions existing, one might expect to find a defi¬ 
nite and normal relation existing at any given time between the spot 
and the futures contract prices, and an absolute uniformity in the 
price of each futures contract throughout its life. The situation 
which would exist on July 1 might be viewed in the following way: 

XA = price of cash wheat on July 1. 

YC —price of June futures on July 1. 

Successive ordinates of AC represent successive prices of cash wheat 
through the year. 

1 Most of these considerations would be included in the statement that the 
supply is known and that the effective demand is such that the total will be con¬ 
sumed during the year and at a uniform rate. It has seemed well, however, to 
put the situation in factual terms so far as possible. 


HEDGING 


229 


AM, AF, AH, AD represent the carrying charges to September 30, 
December 31, May 31, and June 30. 

XM, XF, XH, represent the prices of September, December, and 
May futures; these prices are constant. 

Since, according to the assumptions, the supply is known, its 
availability certain, its total consumption fixed at a uniform rate, and 
all persons concerned are acting rationally, the price on July 1 of wheat 
deliverable the 30th of the following June would be higher by exactly 
the carrying charge between the two dates. 1 The price of cash wheat 
would increase uniformly from the beginning to the end of the year. 

If at any time the “spread” between spot and future prices should 
exceed the amounts indicated there would be an immediate and cer¬ 
tain profit for anyone who would buy cash grain, sell futures, put the 
grain in storage, and later deliver it on the contracts. Under these 
conditions no one could rationally sell any cash grain. If, on the 
other hand, the spread became less than the carrying charge it would 
be unprofitable for anyone to hold any grain, for it would be cheaper 
to sell one’s holdings and replace them by purchasing futures and 
accepting delivery on them. 

A MODIFICATION OF THE ASSUMPTIONS 

We may now modify our assumptions and bring them closer to 
reality by introducing certain factors which may operate to disturb 
the price level. Suppose there occurs a general decrease in the 
desire to consume wheat, on account of the introduction of a popular 
substitute. Or, a more probable occurrence, suppose it is discovered 
during the year that the size of the crop has been underestimated. 
Retaining our hypotheses of complete information and of the necessity 
of getting rid of the entire crop by July 1, it is obvious that the price 
of wheat must immediately fall to a figure which will stimulate con¬ 
sumption sufficiently to move the entire crop into consumption by 
June 30. There is no reason to suppose that such a change would 
affect the premium on futures over spot prices. The triangle A BC in 
Figure 1 would move toward the line XY, decreasing both XA and 
XD, but AD would be unchanged. In like manner changes in the 
proportion of the crop desired for consumption early in the year, 
changes in costs of production, and many other factors which affect 
prices would have the same effect on both spots and futures. Even 

* The important factors in the carrying charge are, of course, storage, interest, 
insurance, and shrinkage. 


230 


RISK AND RISK-BEARING 


the introduction of a carry over into the scheme would not alter the 
relationship of cash and future prices, so far as deliveries in the 
same crop year are concerned (though it would have a marked effect 
on the relation of cash prices in the spring and futures prices for new 
crop deliveries). 

If, however, we assume that, on account of ignorance or economic 
irrationality or on account of physical difficulties in getting the crop 
to market, the holders of a large part of the supply fail to sell it during 
the first half of the year and then dump it on the market for consump¬ 
tion during the last half, the case is entirely different. The only 



Fig. i 

possible result of this situation will be higher cash prices during the 
first half of the year than during the last half; if the buyers of forward 
contracts understand the situation futures prices for spring deliveries 
will correspond to the lower prices which will actually prevail at deliv¬ 
ery dates. 

The result may be illustrated as follows: 

As before, 

XA = cash price in July. 

YC —cash price in following June. 

XD —price of June futures in July. 

The prices of intermediate futures will be such as to reflect the 
anticipated course of the cash grain market. AC will not necessarily 
be straight, and may be of any degree of irregularity, except that it 










HEDGING 


231 


cannot drop below the level of DC by more than the carrying charges 
to June 30 from the time represented by the point of intersection. 

Under such conditions the market would afford very imperfect 
facilities for hedging; 

The premium DA on cash grain over futures contracts is sure 
to disappear. Hence the hedger, if he holds grain long, must expect 
to lose, either by an advance in the price of the futures contract which 
he is “short,” or by a decline in the cash grain which he is “long” or 
by both. There is no inducement to hold grain longer than is neces¬ 
sary. 1 

Such a situation as this seems on the face of things to be highly 
abnormal, and the discussions which postulate the possibility of a 



complete hedge simply assume that the condition depicted in Fig¬ 
ure 1 is “normal” and that in Figure 2 abnormal. Our next task, 
therefore, is to examine the extent to which the terms “normal” 
and “abnormal” have any real application to the varying spreads 
between spot and futures prices. 

In the first place, it must be emphasized that the current assump¬ 
tions concerning normal spreads do not apply to the relation between 
spot prices for old wheat near the end of the crop year and contract 
prices for new crop deliveries. Let us examine the factors which 

1 Of course if DX is large relatively to DA it may be profitable for those whose 
business requires them to own grain at such times to sell hedges against it. The 
hedge increases the probability of a small speculative loss, which must be covered 
by a trade profit, but protects against a large loss due to changes in other fundamen¬ 
tal conditions which affect cash and futures prices alike. 







232 


RISK AND RISK-BEARING 


determine the relative value in May or June of wheat for immediate 
and for future delivery. Consider first the influence of the amount 
of old wheat on hand. So far as the spot market is concerned, this 
constitutes the entire potential supply, and its relation to the demand 
for wheat for immediate consumption is the most important factor 
in determining prices. So far as the July or September prices are 
concerned, on the other hand, the supply of old wheat is of importance 
only as it affects estimates of the total which will be available for 
comsumption during the coming year, of which total the carry over 
of old wheat will constitute only a small fraction. More specifically, 
if in May or June the supply of old wheat is small relatively to the 
amount needed to keep mills in operation and supply current demands 
for flour till the new wheat is fit for grinding, the spot prices at terminal 
markets will have very little relation to the futures prices. On the 
other hand, if the supply of old wheat is large enough so that a consid¬ 
erable part is likely to be carried over to be sold along with the new 
wheat, the spot price will come under the control of the factors which 
determine the price of the futures and is colloquially said to be con¬ 
trolled by the futures. In other words, a shortage of old wheat may 
send the spot price to a level indefinitely higher than the price for 
futures, but an abundance of old wheat cannot send it lower than the 
futures price, except by the “carrying charge,’’ because the surplus 
of old wheat constitutes a part of the prospective supply which deter¬ 
mines the price of the futures. 

Spot prices at different points which are not centers of consumption 
are affected differently by a shortage of old wheat near the end of the 
season. If there are supplies quite near the terminal markets, and 
the situation is not complicated by the presence of a local consumptive 
market, their price will be closely related to the spot prices at the ter¬ 
minals. If there are other supplies so remote that they cannot be 
gotten to the central market before new wheat is expected, their 
price fluctuations will correspond to those for the futures. In general, 
the longer the time required to make delivery at a central market or a 
point of consumption, the lower the spot price will be, provided the 
futures are selling below the cash grain. 

The spread between spot and future prices is the most obvious 
instrument which society uses to control the carry over of grain from 
one crop year to another. If large offerings of old wheat or a prospec¬ 
tive shortage of new results in a premium on future contracts large 
enough to cover the full cost of carrying, storage is encouraged; if a 


HEDGING 


233 


shortage of old wheat or the prospect of a large new crop results in 
cash prices higher than futures, or even above the figure where the 
premium on the futures will cover carrying costs, holders are encour¬ 
aged to market their holdings of old and replace them by purchases 
of futures. The social utility of an adjustment of prices which will 
effect a distribution of the old grain between the two crop years in 
accordance with the relations of present and prospective demand and 
supply conditions is obvious, and in general the system, though imper¬ 
fect, seems fairly effective. The usual situation is a premium on 
cash over the futures. 1 If the market always behaved in a perfectly 
rational way a very small premium on spots over futures would suffice 
to insure that no grain would be carried forward beyond the amounts 
actually needed to supply demands for old grain before the new became 
fully equivalent in quality; for no one could afford to carry forward 
for sale in a future month a commodity which he could more economi¬ 
cally buy for delivery in that month. Some grain is carried over, 
however, especially by farmers, in excess of what is needed, and in the 
face of a practical certainty of lower prices in the fall. 2 

The situation during the fall months is apparently simpler than 
that which exists before the harvest, and the expression “normal 
spread ” has more meaning, but even here there is no uniformity in the 
spreads between cash and futures markets in different years. In the 
assumed setting given earlier we have seen how “a normal spread” 
might be made possible. But the marketing of grain is so irregular 
that there occurs surprisingly often a relative shortage of cash grain 
and surplus of prospective supply. Given a certain state of demand, 
the price of futures tends at this time of the year to be controlled by 

1 To test this point an examination was made of the prices, at Chicago, of cash 
contract wheat and July futures on the first trading day in May for the years 1901 
to 1915 inclusive. Of the fifteen years there were twelve in which at the respective 
low prices of the day cash grain was above the July option at its low point and only 
one (1907) in which the premium on July futures over cash grain was as much as 
2 cents. The figures for the low prices of the day represent the situation more 
accurately than those for the daily high prices, because the futures price always 
represents the bottom of the grade, while the cash quotation may represent any 
quality not quite good enough to be classed in the next higher grade. Accurate 
data as to carrying costs are not at hand, but figuring interest at 6 per cent on 
90 cents a bushel and storage at 1914 rates the cost of these two items approxi¬ 
mated 1.8 cents for the first month and 1.5 cents a month thereafter. 

2 An extreme case occurred in the late spring of 1915, when many farmers were 
holding grain for a rise, although September wheat was selling from 30 to 40 cents 
and July wheat from 15 to 25 cents below the cash quotations. 


234 


RISK AND RISK-BEARING 


the reported size of the harvest, while the spot price depends upon the 
supply of grain actually available. Whenever, on account of bad 
roads, car shortage, railway strikes, farmers’ holding movements, or 
for other reasons, the supply of grain actually coming into the central 
markets is smaller than current reports concerning the size of the har¬ 
vest led the trade to expect, the spot price rises above so-called “ nor¬ 
mal” relation to the futures. A premium on cash over futures is a 
very common phenomenon. For example, on the first trading day in 
November from 1901 to 1915 the lowest price of spot contract grain 
in Chicago was higher than that of May futures, six times, and in 
only three years out of the fifteen was the May future as much as 
seven cents higher than the cash. 1 

Even during the spring months, when we should expect the closest 
correspondence between the spot and the futures markets, there is 
no discernible tendency for the futures prices to equal the cash price 
plus a carrying charge. From 1901 to 1915 there were only nine 
years in which at their respective low points on the first trading day of 
March the May future was higher than the cash contract wheat. A 
similar situation prevailed in other markets. Comparison of the 
lowest prices for cash contract oats and for May futures on the first 
trading day in April, for the years 1901 to 1915, gives the following 
results: May price higher, four times; lower, nine times; the same, 
once; data insufficient, once. Examination of figures for corn prices 
has also failed to show any tendency for the futures to run uniformly 
above the cash. 3 

It is therefore clear that any attempt on the part of a miller or 
other hedger to make money by taking off hedges when the spread is 
abnormal is purely a speculation. 3 No one can ever predict from the 
quotations themselves what either the cash markets or the futures 
markets will do. All that can be said is that the two markets will 
come together by the last day of the month of delivery, but whether 

1 Data from Howard Bartels’ Red Books. 

2 Data from sources previously cited. 

3 The following passage reflects a misunderstanding on the point which seems 
to be widespread: “Terminal elevators sometimes increase their profit by buying 
in their hedge at times when the spread narrows more than is normal. This will 
increase their profits, because, as it will be remembered, the spread at the time 
they bought cash wheat and sold it for future delivery was enough to cover the 
costs of carrying it in addition to some profit. And so, if the spread at the time of 
sale has narrowed more than the normal amount, the profit is increased by so much. 
They can buy again when the spread becomes normal.” Fred E. Clark, op. cit. } 
P- 37 2. 


HEDGING 


235 

the spread will disappear by a rise of the lower price or a fall of the 
higher, or a rise or fall of both with one moving more than the other, 
is a question for the speculator. 

The only element in the entire relationship of the spot and futures 
which may be called a “control” is the fact that at any given time 
the futures prices cannot get above the spot prices by materially more 
than the carrying charge from the date in question to the date of 
delivery. This is true because of the possibility previously noted of 
buying grain in the spot market, selling futures to the same amount, 
carrying until the delivery date, and delivering the actual grain. The 
profit of any trader doing this would consist of the difference between 
the carrying charge (plus commissions and other charges) and the 
premium on futures over spot prices at the time he made the two con¬ 
tracts. Such operations would at once narrow the spread by forcing 
spot prices up and future prices down. 

In this same connection, however, it is worthy of notice that it is 
not to be expected, even if grain is marketed freely, that the futures 
contract prices for all deliveries or for any two deliveries will fully 
discount the carrying charge between them. If the spread between 
the December and the May futures at any time is fully equal to the 
cost of carrying from December to May, any speculator may buy 
December grain and sell the same amount of May, knowing that the 
spread will not become wider, to his detriment, and may become 
narrower, to Ips profit. A speculation offering a chance of profit and 
no chance of loss, even if the chance of profit is not great, is an ideal 
speculation, and the competition of speculators to buy the nearer and 
sell the more distant future is bound to be sufficient to make such a 
situation quite abnormal and only of momentary duration. Spreads 
between futures contracts vary widely. 1 

The carrying charge bears exactly the same relation to the move¬ 
ment of grain into storage and out into the channels of consumption 
which the cost of shipping gold bore to the movement of specie in 
international trade in the days before the war, with this important 
exception, that whereas gold could be shipped in either direction, 
grain can be carried forward for future consumption but cannot be 

1 The price of May wheat at its low point on November 15, or the next trading 
day of the years indicated, varied from the low figure for December wheat on the 
same date by the following amounts: 1908, 4? cents higher; 1909, if cents lower; 
1910, 5! cents higher; 1911, 6f cents higher; 1912, 5^ cents higher, 1913, 4! 
cents higher; 1914, 6| cents higher; 1915, if cents higher. For data on carrying 
charges see notes above, pp. 229 and 233. 


236 


RISK AND RISK-BEARING 


transported back into the past. Hence, as just noted, the premium 
on futures over spot cannot exceed the carrying charge, but the 
premium on spot over futures has no limit, while in the gold trade 
a shift in the premiums could cause a movement in either direction, 
so that the premium and the discount on foreign exchange both had 
definite limits. 


CONCLUSIONS 




In the light of these conditions, the limitations of the hedging 
market are clear. Whenever the cash price is above the futures, or 
below the futures by less than a full carrying charge, there is no such 
thing as a complete hedge for cash grain purchases. If the cash grain 
and the futures contract are selling at the same price, and the carrying 
charge till delivery month is four cents a bushel, the hedging con¬ 
tract will afford the buyer of cash grain complete protection against 
losses of more than four cents a bushel. Losses of less than that 
amount are rendered less probable, for there are many price changes 
due to causes which affect both markets alike, and against these the 
hedge is complete. But there is always the risk that the markets will 
diverge to the extent permitted by the carrying charge. 

It remains to consider the case for the hedge buyer, for example 
the man who has contracted to deliver flour at a fixed price in the 
future and buys futures to protect himself against a rise in prices. 
If his selling prices for flour were based on the cash prices at times when 
the futures prices were lower, he would make an extra profit without 
risk by buying the futures to cover his needs. Under the ordinary 
conditions of competition, however, it is clear that sales of flour for 
distant future delivery must be based on futures prices for wheat; 
hence the purchase of futures is as good a hedge when futures are below 
the spot prices as when they are above. 

Sellers of flour and similar products who protect their forward 
contracts by purchases of future contracts secure complete protection 
if they can wait till delivery date before securing their raw material 
and can use the grades of grain which are tendered on contracts, but 
if they must purchase at intermediate dates their protection is only 
partial, as the spot market in which they must buy their supplies may 
advance without limit above the futures price. 1 

1 Adapted by permission from C. O. Hardy and L. S. Lyon, “The Theory of 
Hedging,” Journal of Political Economy, XXXI (April, 1923), 276-87. 



CHAPTER XIII 


LIFE INSURANCE 

The subject-matter of this chapter is discussed in terms of the 
following outline: 

I. Introductory considerations 

II. The risk insured 

III. Policy contracts 

1. General classification of policies 

2. Classification according to conditions of maturity 

3. Classification according to premium payments 

4. Classification according to number insured 

5. Classification according to right to share in profits 

6. Standard policy conditions 

IV. Insurance company organization 

V. Selection of risks 

VI. Calculation of premiums 

1. Mortality tables 

2. Interest rates 

3. Net premium, annual renewable term policy 

4. Net single premium, whole life insurance 

5. Level annual premiums 

6. Comparison of costs of various types of policy 

7. Loading 

VII. Disbursement of life insurance funds 

1. Expenses 

2. Settlement of claims 

3. Cash surrender values 

4. Policy loans 

5. Dividends 

VIII. Special types of fife insurance 

1. Group insurance 

2. Industrial insurance 

3. Fraternal and assessment insurance 

4. Annuities 

5. War risk insurance 

I. INTRODUCTORY CONSIDERATIONS 

As was indicated in chapter iv, the most important method of 
getting rid of risk in business affairs through transfer to others is the 


237 


238 


RISK AND RISK-BEARING 


institution of insurance. In the same chapter, reference was made 
also to the character of the insurance contract as an agency for reducing 
risk through combination, through special knowledge on the part of 
insurers, and through preventive activity on their part. No further 
attention need be given the social theory of insurance here except to 
point out a contrast between life insurance and other forms of insur¬ 
ance. 

In general, the theory of insurance is that the insured obtains 
a hedge against a contingency which, if it occurs, will cause him 
actual financial loss; and that contracts which purport to insure 
against a contingency involving no financial loss to the buyer of the 
insurance partake of the nature of gambling transactions. 1 

The chief practical consequences of this are, first, the doctrine 
of insurable interest, under which the person seeking to effect insur¬ 
ance is required to show that he has an actual interest in the event 
insured against, and second, the disapproval of overinsurance. In 
many lines of insurance, the liability of the insurer is limited to the 
amount of loss actually realized, regardless of the amount of insur¬ 
ance carried; and in practically all lines effort is made by insurers 
to limit insurance to the amount of risk actually undergone by the 
insured. In life insurance, however, the principle of indemnity can 
receive only partial application. The doctrine of insurable interest 
applies, but where an actual financial interest exists, insurers cannot, 
for obvious reasons, insist on insurance being limited rigidly to the 
amount of the actual risk. The value of a man’s life is too delicate a 
question to be made readily the subject of contractual stipulation. 
Moreover, an individual is always held to have insurable interest in 
his own life; hence he is free to obtain insurance and to make it pay¬ 
able to whom he pleases, without regard to the character of the 
beneficiary’s interest. 2 

In spite of this fact, from the standpoint of the insured and his 
dependents, the question as to what financial hazard is involved in 
his fife risk is as vital as in any other type of insurance. Insurance 
up to the amount required to place the beneficiaries, in the event of 

1 The reader will not fail to note the sharp contrast in this respect between the 
theory of insurance and of hedging. In speculative futures markets, while the 
hedging function is generally asserted to constitute the chief social justification 
of the system, the question whether a given individual in operating through the 
market has an actual risk to hedge does not in any way affect the legitimacy of 
his operations. 

2 This is not true of the insurance written by the so-called fraternal orders. 


LIFE INSURANCE 


239 


the death of the insured, in the same financial position they would 
have been had he lived, is a hedge, and its purchase up to this amount 
may be sound investment policy; insurance in excess of that amount is 
a speculation, and a poor speculation at that, for the premiums are 
always so adjusted that the odds are in favor of the insurer. 

II. THE RISK INSURED 

One of the first questions which arises, therefore, in connection 
with life insurance pertains to the character of the risk against which a 
hedge is sought. The similar question which arises in connection 
with other types of insurance is comparatively simple, but the loss 
due to the death of a given individual is not susceptible of such 
exact determination as is possible with most types of loss. 

What then is the measure of the value of a human life? A 
moment’s consideration will show that the amount of the risk on a 
given man’s life is not closely related to the needs of those who are 
dependent upon him. The primary object of insurance is like the 
objective of any other business transaction which looks to the future, 
that is, not to provide the minimum amount on which a family can 
survive, but to provide the maximum which can be secured without 
a cost in present sacrifices in excess of its value. 

The principles upon which a correct estimate of the value of a 
man’s life must be based are exactly the same as those governing the 
value of any other source of income. The financial value of a man’s 
life is the present worth of the total amount of money which he may 
be expected to earn during the period of his normal working life 
minus the present worth of the total amount of money which he may 
reasonably be expected to expend for personal consumption. That is, 
if a man will earn on the average during the next five years $5,000 a 
year but will spend $2,000 a year for personal consumption or for 
other expenses which will normally be stopped in case of his death, 
the net loss to his family from his death will be $3,000 a year for the 
five years, and the equivalent in cash at the present time will be the 
present worth of a five-year annuity of $3,000, or, at 3 per cent, 
$ x 3 j739- 10 - If his normal working life is more than five years, or if 
his probable earnings above personal expenditures will vary during the 
period, the calculation is more complicated, but the principle remains 
the same. This does not mean, however, that the family need be 
protected by a whole life policy for the amount indicated. If a man 
is assumed to earn $2,000 per year above his maintenance from age 


240 


RISK AND RISK-BEARING 


thirty-five to age sixty-five, the present worth, at 5 per cent of his 
life at age thirty-five is about $30,745, but a year later the value will 
be only $30,282. There will then be only twenty-nine years of work 
left in him instead of thirty, and his value must be written down for 
this 11 depreciation.” On the other hand, the present worths of the 
earnings of all the subsequent years must be written up to take 
account of the shorter period for which they are now to be discounted, 
so that the actual decrease in his capitalized earning power is not 
$1,000 but $463. 

In the case of policies taken out for business purposes, a different 
test of the amount at risk must be applied. Such policies are of 
several types. Sometimes insurance is carried by partners on one 
another’s lives. Sometimes a corporation carries insurance on the 
life of its president or other valued executive. In both cases the 
object of the insurance is to offset the risk of loss to the business 
through disruption of the management. Sometimes insurance is 
carried on the lives of employees under contract, whose services are 
of such a specialized character and whose abilities are so rare that it 
would be difficult to replace them. Baseball players and artists 
are frequently so insured for the benefit of their employers. 

In all these cases the amount at risk must be estimated by deduct¬ 
ing from the value of the services rendered the salary or other com¬ 
pensation which is being paid or is anticipated to be paid during the 
probable continuance of the business relationship. In the case of an 
executive whose personal fortunes are bound up with the future of 
the insuring corporation or partnership, the value of the services may 
properly be capitalized for the whole business* life of the insured, or a 
substantial portion thereof; in the case of employees under contract, 
only the services to be rendered during the term of the contract should 
be considered. Estimating the value of services, particularly where 
the services consist in large part of the use of one’s name, is very 
difficult, but an approximation may be effected stating the question 
in this way: How much additional salary, above that now paid or 
expected to be paid, could the organization afford to pay rather than 
be deprived of the services ? 

Another type of business policy is that taken out to protect the 
interest of a creditor in the life of a debtor. When the debtor pays the 
insurance premiums as a means of securing credit, which is the usual 
situation, the amount at risk is simply the amount of the debt, plus 
any accretions of interest which may arise during the period con- 


LIFE INSURANCE 


241 


templated. If, however, the insurance is effected by the creditor 
and he pays the premiums, or desires to obtain sufficient insurance 
to protect him in case he is compelled to pay premiums in order to 
prevent lapse, a situation arises which has been the source of much 
confusion. It has been held, and the courts have at times sustained 
the view, that in this case there is an insurable interest amounting to 
the principal of the debt plus the premiums which the creditor would 
have to pay if he kept the insurance alive through the probable life 
of the debtor, plus interest. This appears plausible, but it is utterly 
impossible of application, for the reason that no matter whether the 
insurance be large or small in amount, it will inevitably be exceeded 
by the amount of premiums required to keep it in force through the 
life expectancy of the insured, with interest. If this were not true, 
the contract would be an impossible one for the insurance company 
to fulfil. 

in. POLICY CONTRACTS 

The contract of life insurance is expressed in a document known as 
a policy. The life insurance policy is distinguished from most other 
types of contract by the following peculiarities. First, it is a uni¬ 
lateral contract. That is, the insured may cancel the contract at 
any time, and under certain conditions may even recover a portion 
of what he has paid under its terms, while the insurance company 
has no such option, but is bound by the contract so long as the insured 
fulfils his obligations. 

Second, although the contract is an agreement between two parties, 
the insurer and the insured, there is usually involved a third party, 
known as the beneficiary, to whom the insurance is payable in the 
event of the death of the insured within the life of the contract. 
Though not a party to the contract, the beneficiary may have title 
to the policy. Whether this is the case depends on the form of the 
contract. If the policy contains what is known as a “change of 
beneficiary clause,” that is, a clause giving the insured the right to 
change the beneficiary at will, the title vests in the insured, and he 
may be required to assign it |or the benefit of creditors in the event 
of his own insolvency. If tflere is no such clause, the beneficiary’s 
consent is necessary for a change of beneficiary, and creditors have no 
claim to the surrender value of the policy. In either event, under the 
laws of most states, the proceeds of a policy payable to wife or children, 
if matured by death of the insured, are not liable for the debts of the 
insured, even though he was insolvent at death. Nor^can such 


242 


RISK AND RISK-BEARING 


funds, as a rule, be seized by creditors of a widow or minor children, 
so long as they are not mingled with other funds which are subject 
to such seizure. 

A third peculiarity of the life insurance policy contract is the high 
degree of standardization which it displays. The details differ widely 
from one company to another, but the most important features of the 
contracts written by one company are almost identical with those 
written by another, so that it is possible to classify and describe them 
almost without reference to the peculiarities of practice of different 
companies. 1 

The standard types of policy may be classified on any one of several 
bases, as is indicated in the following outline: 

CLASSIFICATION OF LIFE INSURANCE AND ENDOWMENT POLICIES 

I. According to conditions of maturity 

1. Term insurance 

2. Whole life insurance 

3. Endowment life insurance 

4. Pure endowments 

5. Life annuities 

6. Life insurance with disability provisions 

II. According to method of payment of premiums 

1. Single premium 

2. Limited payment life 

3. Level premium 

4. Natural premium 

III. According to number of insured persons 

1. Individual 

2. Joint life 

3. Group 

IV. According to type of insurer 

1. “Old line” or legal reserve policies 

2. Fraternal benefit certificates 

3. Assessment agreements 

4. Government (war risk) policies 

5. Miscellaneous agreements of insurance 

V. According to the right of the insured to share in profits of the insurer 

1. Participating 

2. Non-participating 

x This statement refers particularly to the contracts written by so-called old 
line insurance companies. Fraternal and assessment insurance, which differ 
radically from other types of life insurance, are discussed below. 


LIFE INSURANCE 


243 


Let us consider first the classification according to conditions of 
maturity. 

A term insurance policy is a pure insurance contract. It provides 
insurance for a stipulated term of years, for a premium which may be 
paid either in advance or in a series of annual, semiannual, or quarterly 
payments. In case of lapse, there is, as a rule, no refund to the insured, 
and in case of expiry before the death of the insured the obliga¬ 
tion of the insurer ceases. Renewable term policies have the additional 
feature that the insured is entitled at the expiration of the policy to 
take out another contract without medical examination at the rate 
which he would be charged at his attained age if he were accepted as a 
new applicant. Convertible term policies provide that the insured 
may at any time during the life of the contract, or at its expiration, 
exchange his policy for one of the other standard types of insurance 
contract, either paying the premium, which would be due if he were 
taking out a new contract at the time of conversion, or else taking the 
rate which would have been appropriate to his age at the time of the 
original application, and paying the back premiums with interest. 

Whole life policies provide that the insurance shall extend through¬ 
out the life of the insured. As is the case with term insurance, various 
options as to manner of payment of premiums are offered. The whole 
life policy with level annual premium is the most popular of the 
standard types of policy. 

Endowment life policies provide insurance for a stipulated term of 
years, most often twenty, with the provision that in case the insured 
survives the term of the contract the insurance is due at once. The 
pure endowment, a rare contract in its simple form, provides for the 
payment of a stipulated sum only in case the beneficiary survives a 
definite period. Life annuities provide an income of a stipulated 
amount throughout the life of the beneficiary. The life annuity is 
really a series of pure endowments for successive periods. Disability . 
clauses in life insurance policies provide that the total and permanent 
disability of the insured shall operate either to terminate liability for 
further payment of premiums, or to mature the policy, or otherwise 
modify the terms of the contract. 

Classification according to method of payment of premiums.—Single 
premium insurance is paid for in advance in a single payment. Limited 
payment life contracts provide insurance through the whole life but 
limit the premium-paying period to a term of years, most frequently 
twenty. Level premium means a uniform payment throughout the 


244 


RISK AND RISK-BEARING 


premium-paying period. The most frequent types are the level 
annual premium and the level weekly premium collected on so-called 
industrial policies. A natural premium is a premium which increases 
from year to year as the risk increases. This type of premium is 
most frequent in renewable term policies. 

Classification according to number insured. —This classification is 
nearly self-explanatory. Individual policies cover single lives; joint 
life policies mature at the death of either of two or more persons; 
group policies are written to cover a large number of persons jointly. 
Group policies differ from joint life policies in that they are not 
terminated by the death of one of the insured. 

The classification of policies according to type of insurer is given 
detailed consideration in later sections of the chapter, and need not 
be analyzed here. 

Classification according to right to share in profits. —Participating 
policies provide for the return to the insured of a portion of his premium 
in the event that earnings of the insurer justify such a “dividend.” 
Customarily the premiums on such policies are made high enough so 
that there is sure to be some dividend. In other words, the dividend 
is in part a rebate of excess premium and only in part a true dividend 
or distribution of profits. Non-participating policies, as" the name 
implies, carry no claim to dividends. “Participating policies at non¬ 
participating rates” are sold by a few companies. These are partici¬ 
pating policies whose premium rates carry no excess “loading” to 
provide for dividends, hence pay only relatively small amounts, which 
are, however, true dividends. 

Standard policy conditions. —The conditions embodied in standard 
types of policy issued by the majority of companies have been sum¬ 
marized by one writer as follows: 

1. A copy of the application is attached to the policy, so that the 
insured may be in possession of the complete contract. 

2. The policy contains a clause setting forth that it shall not go into 
force and effect until delivered during the lifetime and good health of the 
insured, and after the required premium has actually been paid. 

3. The majority of companies have some restrictions relating to hazard¬ 
ous occupations during the first or first two policy years. 

4. Most companies have some restrictions pertaining to military and 
naval service during war. 

5. Practically every policy contains a “suicide clause” in one or another 
form. 

6. The policy becomes incontestable after one or two years. 


LIFE INSURANCE 245 

7. Provision for reinstatement of lapsed policies is made under varying 
conditions. 

8. Thirty-one days’ grace is allowed in the payment of every premium 
after the first. 

9. Participating policies contain a clause stating the conditions under 
which dividends will be paid. 

10. Every policy embraces a table specifically indicating the surrender 
values and loans available in each year, generally beginning with the third. 

11. Most companies undertake to pay claims immediately after the 
receipt of proofs of death. 1 • 

Most of these clauses require no explanation. The suicide clause, 
formerly very sweeping in the policies issued by many companies, 
now generally covers only the first policy year. Its effect is to free 
the company from liability in the event that the insured dies by his 
own hand, whether sane or insane. The clauses relating to military 
and naval service usually only have application to the first one or two 
years, and the same thing is still more generally true of the clauses 
which restrict the insured in the choice of occupations and in his 
freedom of travel. 2 In all these causes, the intent of the clause is 
not to protect the company from liability in the case of such indi¬ 
viduals as would normally run the proscribed hazards, but simply to 
prevent the insurer’s securing an undue proportion of such • hazards 
on account of a tendency of people to take out insurance after they 
have decided to commit suicide, to engage in dangerous occupations, 
or to travel in unhealthy environments. 3 The “incontestable clause” 
operates to debar the company from contesting the policy after a 
specified time, usually one year. Exception is always made of certain 
cases, including those in which the policy is invalidated on account 
of non-payment of premium, and sometimes such other items as 
military and naval service, fraud in application, etc. In case the 
age of the applicant has been understated, the company’s remedy is 
not cancellation of policy, but the reduction of its liability to such 
amount as the premium actually paid would have purchased at the 
correct age of applicant. Incontestable clauses never waive the 
application of this remedy. 

1 Forbes Lindsay, The Policy Contract , p. 88. (Pamphlet published by the 
Pacific Mutual Life Insurance Company of California.) 

2 During the Great War most insurance companies waived restrictions on 
military and naval service, so far as the services of their own countries were con¬ 
cerned. 

3 Cf. discussion of adverse selection, p. 247. 


246 


RISK AND RISK-BEARING 


IV. INSURANCE COMPANY ORGANIZATION 

Aside from the fraternal and assessment associations described 
in a later section, life insurance organizations fall into two groups, 
known respectively as stock and mutual companies. A stock company 
is a business corporation organized to carry on the business of selling 
life insurance. In internal organization such a corporation differs 
little from corporations organized for other purposes. Customarily, 
its surplus is very large in proportion to its capital stock, for the 
reason that in its early history an insurance company requires but 
little capital, and the need for additional capital as its business 
expands can be met by accumulation of surplus more readily than is 
the case with corporations in most lines of business. The amount of 
owned capital needed, whether in the form of stock or of surplus, 
grows relatively smaller with the growth of the business, for the 
reason that very little of the capital is used for operating purposes. 
The insurance company’s services are paid for in advance, and reserves 
owned by the policyholders are carried to meet the demands for dis¬ 
bursements which arise in the ordinary course of business. The 
function of the owned capital is to serve as a secondary reserve 
against abnormally high mortality experience, shrinkage in value of 
investments, or other contingencies which may make the theoretically 
adequate reserve insufficient to protect the interests of policyholders. 
As the scale of business grows larger, the probability of considerable 
deviations of actual from anticipated experience grows less; hence 
the expansion of capital need not be proportionate to the growth of 
the business. t 

Mutual companies have no stock. Their surplus as well as their 
reserves belong to the policyholders, the difference being that the 
reserve is an aggregate of individual reserves, each of a definite amount, 
while the surplus is a single fund, the joint property of the entire group 
of policyholders. The surplus alone performs the function which in 
stock companies is performed by the combined capital and surplus. 
It is the usual practice in organizing mutual companies to start with 
capital stock which is to receive a fixed rate of return, if earned, and 
to be retired by repayment to the stockholders when the surplus 
becomes sufficiently large to render such retirement safe. Sometimes 
a mutual company is formed by the retirement of capital stock of a 
stock company which was formed with no intention of mutualization. 

Mutual companies are subject to the control of policyholders, 
who elect the trustees and officers. Since the policyholders are always 


LIFE INSURANCE 


247 


numerous and widely scattered, the individual policyholder, as a rule, 
has very little interest in the results of elections, and the tendency 
is strong for control once lodged in a certain group of individuals to 
remain in their hands so long as they care to exercise it. In this 
respect, however, there is little difference between the situation in a 
mutual company and that in a stock company with numerous small 
stockholders. 

Stock companies are far more numerous than mutual, but so many 
of the larger companies are of the mutual type that the volume of 
business done by the mutuals is decidedly in excess of that done by the 
stock companies. 

V. SELECTION OF RISKS 

One of the most important problems confronting the management 
of any insurance company is the proper selection of risks to be insured. 
This is particularly true in life insurance, for the reason that the com¬ 
pany has no option of canceling the contract, if after completion it is 
found to be unfavorable to the company’s interests. 

In a consideration of the methods used in selecting risks, it must 
be emphasized at the outset that it is not the purpose of selection to 
secure for the company an abnormally favorable experience. Insur¬ 
ance rates are based on statistical experience of mortality, and if the 
statistics are representative of the group to be insured there is no 
occasion for precautions to obtain a more favorable result than that 
which they forecast. The necessity for selection in favor of the insurer 
arises from the necessity of preventing selection adverse to its inter¬ 
ests, for there is a constant tendency for persons who believe them¬ 
selves to be poor risks to present themselves as applicants for insur¬ 
ance in greater proportionate numbers than do good risks. It has 
been well said that an insurance company could afford to insure at 
uniform rates all the people who pass a certain street corner on a given 
day, provided the fact of such intent were not made public, but if the 
facts were known a stream of the lame, the blind, and the stricken 
would be sure to pass that corner. In order to prevent discrimination 
against themselves, insurers are obliged to examine every application 
with great care, and the necessity for this scrutiny adds greatly to 
the expense of effecting insurance. 

The principal methods used in selecting risks are, first, discrimina¬ 
tion against certain occupations; second, discrimination against resi¬ 
dents of certain localities; third, discrimination against individuals 
who attempt to procure insurance in amounts obviously in excess of 


248 


RISK AND RISK-BEARING 


their normal needs—this includes cases in which the beneficiary has 
no insurable interest in the life of the insured; fourth, inspection and 
inquiry, designed to aid in estimating the moral hazard; fifth, medical 
examination; and sixth, family history. In the better companies, 
the medical examination is very thoroughgoing, and frequently 
results in the discovery of defects previously unknown to the applicant. 

The immediate result of all these methods of selection is to secure, 
not the homogeneous group of risks aimed at, but the introduction of a 
group of extra-favorable risks. At the earlier and middle years of 
life, the mortality among persons who have recently passed an exami¬ 
nation for life insurance is about half the normal mortality of those 
whose examination was five or more years previous. The “benefit 
of selection” decreases rapidly and is imperceptible after five years. 

VI. CALCULATION OF PREMIUMS 

The following discussion of the method by which life insurance 
premiums are determined makes no pretense of constituting an ade¬ 
quate discussion of the actuarial problems involved in the science of 
life insurance. Actuaries have developed a considerable body of 
mathematical science, making possible the calculation of premiums 
with a minimum of labor. The formulas given in this chapter are 
the basic formulas from which the actuarial short cuts have been 
developed, and are useful from the standpoint of justifying the rates 
rather than actually calculating them. 

The calculation of an appropriate rate for an insurance policy 
requires that two fundamental assumptions be made. First, the 
assumption that among the group of insured deaths will occur with a 
definite frequency, and second, that the funds paid into the insurance 
company will be invested to yield a definite rate of interest. Both 
the rate of mortality and the interest earnings are of course estimates, 
and in the case of contracts which have to run for periods varying 
from less than a year to perhaps seventy-five years, there is obviously 
room for a considerable variance of opinion in making the estimate, 
and consequently a necessity for conservatism in making up the rates, 
so as to insure solvency on the part of the insurer throughout the life 
of the contract. 

The standard device for calculating the rate of mortality is the 
mortality table, which enumerates the anticipated number of deaths 
from year to year in a hypothetical group of lives. The table most 
frequently used for this purpose in America, the so-called American 
Experience table, runs as follows: 


LIFE INSURANCE 


249 


AMERICAN EXPERIENCE TABLE OF MORTALITY 


Age 

Number 

Living 

Number 

Dying 

10. 

100,000 

749 

11. 

99,251 

746 

12. 

98,505 

743 

13. 

97,762 

740 

14. 

97,022 

737 

IS. 

96,285 

735 

16. 

95,550 

732 

17. 

94,818 

94,089 

729 

18. 

727 

19. 

93,362 

725 

20. 

92,637 

723 

21. 

91,914 

722 

22. 

91,192 

721 

23. 

90,471 

89,751 

720 

24. 

719 

25. 

89,032 

718 

26. 

88,314 

718 

27. 

87,596 

718 

28. 

86,878 

718 

29. 

86,160 

719 

30. 

85,441 

720 

31. 

84,721 

721 

32. 

84,000 

723 

33. 

83,277 

726 

34. 

82,551 

729 

35. 

81,822 

732 

36. 

81,090 

737 

37. 

80,353 

742 

38. 

79,611 

749 

39. 

78,862 

756 

40. 

78,106 

765 

4i. 

77,341 

774 

42. 

76,567 

785 

43. 

75,782 

797 

44. 

74,985 

812 

45. 

74,173 

828 

46. 

73,345 

848 

47. 

72,497 

71,627 

870 

48. 

896 

49. 

7o,73i 

927 

50. 

69,804 

962 

51. 

68,842 

1,001 

52.. 

67,841 

1,044 


Age 

Number 

Living 

Number 

Dying 

53. 

66,797 

1,091 

54. 

65,706 

1,143 

55. 

64,563 

1,199 

56. 

63,364 

1,260 

57. 

62,104 

1,325 

58. 

60,779 

i,394 

59. 

59,385 

1,468 

60. 

57,917 

1,746 

61. 

56,371 

1,628 

62. 

54,743 

i,7i3 

63. 

53,030 

1,800 

64. 

51,230 

1,889 

65. 

49,341 

1,980 

66. 

47,36 i 

2,070 

67. 

45,291 

2,158 

68. 

43,133 

2,243 

69. 

40,890 

2,321 

70. 

38,569 

2,39i 

7i. 

36,178 

2,448 

72. 

33,730 

2,487 

73. 

3i,243 

2,505 

74. 

28,738 

2,501 

75. 

26,237 

2,476 

76. 

23,761 

2,43i 

77. 

21,330 

2,369 

78. 

18,961 

2,291 

79. 

16,670 

2,196 

80. 

14,474 

2,091 

81. 

12,383 

1,964 

82. 

10,419 

1,816 

83. 

8,603 

1,648 

84. 

6,955 

1,470 

85. 

5,485 

1,292 

86. 

4,i93 

1,114 

87. 

3,079 

933 

88. 

2,146 

744 

89. 

1,402 

555 

90. 

847 

385 

91. 

462 

246 

92. 

216 

137 

93. 

79 

58 

94. 

21 

18 

95. 

3 

3 


This table was prepared in the late sixties from the experience of 
two life insurance companies, and is not, as a matter of fact, an accu¬ 
rate table. Typically the experience of life insurance companies 
shows that the deaths in a given year are not more than from 65 to 
75 per cent of those anticipated according to the table. More 
accurate tables have been compiled in recent years, but their adoption 







































































































250 


RISK AND RISK-BEARING 


is retarded by two considerations. In the first place, a tremendous 
amount of expense would be involved in changing from one table to 
another. In the second place, since the error consists of an over¬ 
statement of the mortality, its effect is to give the insurer a margin 
of safety, so that there is little inducement for any company to be the 
first to break away from the established practice. An overstatement 
of the mortality by 30 or 40 per cent does not necessarily mean that 
the insured is charged a correspondingly excessive premium. The 
premium includes not only a mortality charge but an allowance for 
expenses, and if the margin of safety in the mortality table were 
removed by the adoption of a more accurate table, the allowance for 
expenses would have to be increased. In fact, a few companies now 
write certain policies for a premium equal to that required by the 
theoretical mortality and the theoretical interest rate, getting their 
entire expense allowance out of the mortality saving and the surplus 
interest. So long as competition is active, the question whether the 
mortality table is a high or a low table presumably does not have 
very much bearing on the rates that will be charged. It does have 
a very definite bearing, however, on the relative rates charged for 
insurance at various ages and for this reason the continued use of a 
table which is now obsolete and probably never was accurate offers 
ground of criticism. 

Interest rate .—The other fundamental assumption of actuarial 
science is the assumption of a rate of interest to be earned on the 
funds which are being accumulated during the life of the insured. 
The rates most frequently used at the present time for this purpose are 
3 and 3! per cent. Judged by the rates which have prevailed in the 
investment market during the last few years, these rates seem very 
low. It must not be forgotten, however, that the reserve on a given 
policy may remain in the company’s hands for half or three-quarters 
of a century, and the company must guarantee its rates to the policy¬ 
holder for a corresponding period. When the states first began estab¬ 
lishing legal tests for solvency of insurance companies some sixty-five 
years ago, the rates used were nearly always either 4 or 4! per cent. 
These rates were considered conservative, and they were in fact well 
below the actual earnings of well-managed companies. For forty 
years, however, the trend of interest rates was downward, and the 
states have twice had to change the rate to a lower one. Therefore, 
despite the high rates to be obtained on safe securities during recent 
years, it does not seem unlikely that before the maturity of contracts 


LIFE INSURANCE 


251 


now open, 3 per cent will once more seem a fair return on such high- 
grade security as that offered by the policies of strong life insurance 
companies. 1 

Before examining the methods used in calculating premiums, 
several terms must be defined. The net premium is the amount which 
the insurance company must charge, assuming a given mortality 
table and interest rate, in order to meet the claims of holders of 
maturing policies, without allowance for expenses or profit to the 
insurer. The loading is the amount added to the net premium to 
provide for these elements. The gross premium is the actual premium 
charged, being the sum of the net premium and the loading. The 
mortality charge is that portion of a premium which is required to meet 
death claims during the year in which the premium is collected. The 
reserve is the accumulated fund resulting from the excess of net 
premiums over mortality charges, together with interest accumulations 
on the reserve itself. The surplus is the fund of accumulated profits 
of the insurer. It arises from four principal sources: deficiency of 
mortality below that anticipated in accordance with the table; 
excess of interest earnings on the reserve over the rate assumed in 
figuring the premium; excess of loading over actual expenses incurred; 
and interest on the surplus itself (in the case of a stock company on the 
capital also). 

The simplest type of rate-making problem is presented by the 
annual renewable term policy. To simplify it still farther, we will, 
for the present, disregard expense loading and confine attention to 
the calculation of the net premium. 

Let us assume then that we wish to insure for $1,000 each for one 
year a group of men of normal health of age thirty-five. Our first 
problem is to determine the risk. The American Experience Table 
of Mortality shows that of 81,822 men living at age thirty-five, 732 

732 

will die within one year. The risk, therefore is, ^ and if the 
premiums were paid at the same time that the policy falls due, the 

w X OOO X 7^2 

net premium charge would be | 8i822 > or $ 8 - 95 - However, insur¬ 

ance premiums are paid at the beginning of the year and death losses 
are paid after the deaths occur. An accurate calculation, therefore, 
must take account of interest on the premiums from the tune they are 

1 Cf. Zartman, Life Insurance Investments , pp. 55-60. (Henry Holt & Co., 
1906.) 




252 


RISK AND RISK-BEARING 


paid until the average time that the death losses occur. This is han¬ 
dled in practice by the simple assumption that the losses are all paid at 
the end of the year. Such an assumption is of course inexact. If death 
losses occurred uniformly during the year, the average time from the 
payment of premiums to the death of the insured would be six months, 
and the average time till the payment of the policy would be somewhat 
greater, say seven months. Since the mortality rate increases with 
advancing age, the actual tendency is for more than a proportionate 
number of deaths to occur in the latter part of each insurance year, 
hence the average time till the date of payment is still further length¬ 
ened. It is however considerably less than the full year assumed 
in the insurance calculations, and to that extent the standard method 
of calculation involves an injustice to the insuring company, which 
must be offset by an allowance favorable to the company at some other 
point in the calculations. As we have seen previously, the mortality 
tables overstate the actual mortality; this circumstance much more 
than offsets the advantage which the insured gains from the assump¬ 
tion of payment at the end of the policy year. 

The present worth at 3 per cent of $1 due one year hence is 
$.970874. Under the terms of the contract, an insurance company 
issuing 81,822 policies may expect to have to pay 732 losses, which 
we will assume to be of $1,000 each. The present worth of $732,000 
due one year hence may be expressed as $1,000 X 732 X .970874, 
which is the amount the company must collect in premiums at the 
beginning of the year. The net premium on one $1,000 policy is 
therefore 


$i,oooX 732 X .970874 

81,822 


or $8.69. 


Our next step is to develop the net single premium for whole 
life insurance. This is the amount which paid in at once to the 
insurance company will enable it to pay each of the insured the face 
of his policy at the time of death. This involves simply a repetition 
of the preceding calculation for each successive year of life to the end 
of the mortality table. Out of a group of 81,822 persons of age thirty- 
five, the table shows that 737 will die at age thirty-six. To provide 
for losses on their policies, we must have in hand, not $737,000, but 
an amount which, if kept at interest for two years, will amount to 
$737,000 or $1,000X73 7 X.970874 2 . In like manner, to provide 
for the losses of the third year, we must have in hand $i,oooX742X 
,970874b and to provide for the death losses of the ninety-fifth year, 



LIFE INSURANCE 


253 

when the last three survivors are expected to die, we will need $i,oooX 
3X.970874 61 . The sum of the amounts necessary for payments 
due on account of those who die in the various years of life is of 
course the amount required to provide for all the death claims, and this 
sum divided by 81,822 is the necessary contribution of each member of 
the group. This is known as the net single premium for a whole life 
policy for $1,000 at age thirty-five. 

Annual renewable term policies and whole life policies sold for 
single premiums are rare. The most common type of insurance is the 
whole life policy with level annual premium, and it is this premium 
which we must next examine. The expression for this premium, using 
the same age, interest rate, and mortality table as before, is 

$1,000 (732X.970874+737X.97o874 2 + 3X.970874 61 ) # 

81,822+81,090X.970874+80,353X.970874"+ .... +3X.970874 60 ’ 

This formula is derived as follows: The numerator represents the 
sum of the present worths of the amounts to be paid out during each 
year of life, and is the same as the net single premium calculated 
above, except that it has not been divided by 81,822. In other words, 
it is the net single premium for the group, not for the individual policy. 
The denominator represents the sum of the present worths of the 
amounts, which will be paid in to the insurance company if each of the 
insured pays one dollar a year for his natural life. One dollar from 
each of the insured yields $81,822, which is paid now; $81,090 will 
be paid one year hence by the survivors at that time, and therefore 
must be discounted at 3 per cent; $80,353 will be paid in two years and 
is discounted at 3 per cent compound interest for the two years; so 
we proceed to the sixty-first term, which is the present worth of $3, 
paid by the three survivors sixty years hence. Since the numerator 
of our fraction represents the present worth of the series of sums which 
the insurance company has to pay out, and the denominator repre¬ 
sents the present worth of the series of sums which the company would 
take in if it charged each policyholder $1 a year, the fraction, as a 
whole, must represent the number of dollars a year which each of the 
insured must pay during his lifetime in order that the company may 
come out even on the whole transaction. 

If this formula is thoroughly understood, the derivation of the 
premiums for the other usual types of insurance is comparatively 
easy. If, for instance, we desire to obtain the premium for a twenty- 
payment life policy, we notice that the sums to be paid out by the 



254 


RISK AND RISK-BEARING 


company are exactly the same as under a whole life policy, but that 
the premium receipts stop at the twentieth payment, nineteen years 
hence. Hence, we keep our numerator unchanged, but cut off all 
but the first twenty terms of the denominator. If a twenty-year 
term policy is in question, the level annual premium is obtained by 
taking the first twenty terms of both the numerator and the denomi¬ 
nator, the first twenty terms of the numerator representing the 
amounts to be paid out, those of the denominator representing the 
amounts that will be received in that time at $i a year from each 
surviving member of the group. For a twenty-year endowment 
policy, the calculation is the same as for a twenty-payment life policy, 
except that for the last term of the numerator we must substitute 
“$i,000X65,706X. 970874 20 ,” the numeral 65,706 representing the 
total number who survive to age fifty-four. Some of these will die 
during that year, the rest will draw $1,000 each at the end of the 
year; for purposes of calculating the premium the result is the same 
as though all died during the year. This calculation is therefore 
exactly the same as the calculation for a whole life policy would be if 
the mortality table showed that all survivors died at age fifty-four 
instead of age ninety-five. It will be noticed that the whole life policy 
is the same thing as an endowment at age ninety-six, and is also the 
same thing for purposes of figuring the premium as a sixty-one-year 
term policy at age thirty-five. 

The premium for single payment life is obtained in exactly the 
same way as the premium for twenty-payment life, except that only 
the first term of the denominator is retained, instead of the first twenty 
terms, giving us the expression: 

$1,000 (732X.970874+ 737X.970874 2 .... 3X.97Q874 61 ) # 

81,822 

The premium for a whole life policy is much larger than the 
premium for annual renewable term insurance at the same age. 
In other words, the purchaser of a whole life policy pays in the early 
years considerably more for his insurance than it costs the company 
to furnish it. The excess premium is held in reserve to enable the 
insurance company to furnish insurance at less than the mortality 
charge in the later years of life. 

The sum total of these excess payments, together with their 
accumulated interest, constitutes what is known as the reserve. The 
reserve is not the property of the insurance company but is of the 



LIFE INSURANCE 


255 


nature of a trust fund held by th t insurance company as an advance 
payment for insurance to be furnished later. It should be noted, 
carefully, however, that the amount in the reserve does not depend 
on the actual mortality of the insured group nor on the rate of interest 
actually earned. It is the amount which would accumulate if the 
mortality ran exactly according to the table and the interest earnings 
were exactly as assumed. Any saving or gain due to lowered mortality 
or higher interest earnings goes not into the reserve but into the 
surplus, and is the property of the company. 

The theory underlying the popularity of all types of level premium 
insurance is, that if insurance is charged for at the current cost of 
furnishing the insurance, the cost gets prohibitively high in the later 
years of life. It will be seen, however, from the foregoing analysis 
of the way in which the,premium is calculated, that the cost of insur¬ 
ance in the later years of life is just as great on the level premium plan 
as under the natural premium plan. The only differences are that 
under the level plan the individual pays a part of the cost of his 
insurance many years in advance and is credited with the interest at 
about the savings bank rate on these payments; and second, that under 
this plan those who die in the early years of life get no added return 
for the added payment they have made, while those who live through 
to an advanced age get the benefit of a lower premium on account 
of the contributions of their fellows. Of a typical group insured at 
age thirty-five, 20 per cent die within twenty years. The difference 
between what this 20 per cent pay for insurance under a level plan and 
what they would pay under the natural premium plan is their loss and 
the other policyholders’ gain. This gain brings up the return on 
their advance payments for the 80 per cent who survive, from 3 or 3 \ 
per cent to about 5 per cent. In other words, the level premium plan 
offers the policy-buyer, in early middle life, a combination of two 
opportunities: First, to buy an insurance policy at what is presumably 
a fair rate for. the insurance, and second, to invest the difference 
between the cost of insurance and the level premium in a security which 
offers a 20 per cent chance of loss and a 5 per cent rate of return, if the 
loss does not occur. Surely such a contract hardly constitutes an 
extremely attractive speculative investment. If it is judged favorably, 
it must be on account of its insurance, not its investment, feature. 

What has just been said in disparagement of whole life, as com¬ 
pared with renewable term insurance, applies with much more force 
to limited payment life policies and with the greatest force to endow- 


256 


RISK AND RISK-BEARING 


ment policies. In these higher-priced policies, the proportion of the 
premium which pays for the insurance service is relatively small and 
the remainder is an investment on which nothing will be realized 
unless one lives out the term of the contract, and no more than good 
interest if he does. 

It is true that under the renewable term plan the cost of insurance 
becomes relatively very high after about age fifty-five. But, quite 
apart from the fact that many men no longer have dependents by the 
time they reach that age, it must be remembered that the amount 
of insurance needed by the time that age is reached is comparatively 
small, even if there are persons totally dependent on the earnings of 
the insured. At age fifty-five the average man has no more than ten 
years’ probable earning life, and even though those be years of high 
earnings, the capitalized value of the short period is much less than 
the loss in case of death earlier in life. Moreover, if the money saved 
by buying term insurance, rather than limited payment or endow¬ 
ment policies, has been invested in safe securities the savings accumu¬ 
lations have operated to reduce the volume of insurance needed in 
the later years of life. The logical plan, therefore, is to reduce the 
amount of insurance during the later years in order to offset the effect 
of the rapidly advancing renewal rate. 

It will be argued in reply that man will not save except under 
pressure, and that the endowment or limited payment policy is there¬ 
fore the better purchase because it stimulates a more or less automatic 
type of saving. There are undoubtedly cases where this has been true, 
and the argument is not without force, though it can hardly be argued 
that enforced saving is always a gain. There must be some cases 
where the savings are carried over from a time when they are more 
needed to a time when they serve a less important want, but they are 
probably relatively few. It is undoubtedly true that most men who 
buy low-priced policies are apt to spend, rather than save, the money 
they thus cut off their insurance bill. But most meij who take out 
high-priced insurance policies do not keep up the payments on them 
either. 

There is no real pressure on anyone to keep up premium payments 
after a policy has been in force long enough to make the full reserve 
available as a surrender value; indeed the larger the surrender value 
grows, the greater becomes the incentive to take advantage of it. 

The most serious practical objection to investment insurance is 
the fact that the saving it represents is nearly always made at the 


LIFE INSURANCE 


257 


expense of needed protection. Most men in moderate circumstances 
carry far less insurance than is necessary to protect their families. 
They cannot afford the premium payments necessary to give complete 
protection if in order to secure the protection they must also make 
payments to accumulate an endowment fund or to pay for the cost 
of protection at the advanced years of life; if pure protection were 
readily available and were encouraged as a sales policy, there would 
probably be a great increase in the amount of protection carried. 

Loading .—It remains to consider the procedure by which the 
theoretical premium derived from the mortality and compound inter¬ 
est tables is weighted to provide for the expenses connected with the 
operation of the insurance company, the dividends paid to stockholders 
or policyholders, and the increase of surplus which is necessary if the 
company is to be enabled to take care of an increasing volume of 
business with safety. The addition to the net premium made for 
these purposes is called the loading. 

The process of figuring loading is less scientific than that employed 
in figuring net premiums, and the results obtained differ greatly from 
one company to another. The difficulty in determining proper loading 
arises from the fact that while most companies write a wide variety 
of policies, the major part of their expenses are either jointly due to 
the whole volume of business, or if attributable to specific policies 
cannot be assessed to them accurately in advance. Approximations 
must be made, and the degree of accuracy in these approximations, 
which it is worth while to aim at, is a matter concerning which opin¬ 
ions differ widely. 

The following are the fundamental principles which are generally 
accepted as governing the proper distribution of expense: First, all 
expense directly attributable to the investment operations is taken 
care of by the investment department. This expense appears as a 
reduction in the percentage earned on the investments; hence does 
not have to be taken account of in the loading. Second, expenses 
which vary with the amount of the premium (such as commissions) 
are best assessed as a percentage of the net premium. Third, expenses 
which vary with the size of the policy, and in general those which do 
not fit into either of the other categories are best taken care of through 
a charge proportionate to the face of the policy. General adminis¬ 
trative expenses and settlement costs are examples of the charge most 
often assessed in this manner. It is this third group of expenses 
which are handled in the least satisfactory manner, as a considerable 


258 


RISK AND RISK-BEARING 


proportion of the expenditure really depend on the number of separate 
policies rather than on their size. The logical method of assessing 
these costs would be a flat charge of so much per policy, but such a 
charge is never used in practice, presumably because it would make 
the smaller policies disproportionately expensive and thereby create 
difficult problems for the sales force. 

The methods usually employed are the following, the details of 
application showing, as already noted, great variation: (a) a straight 
percentage of the net premium; ( b ) a percentage varying with the 
type of policy; (c) a flat sum plus a percentage of the net premium; 
(d) a percentage of the net premium plus the same percentage of the 
corresponding net premium for ordinary life policies. The last 
method is defended on the ground that the cost of the insurance 
features of the contract, rather than the cost of the combined insur¬ 
ance and investment features, should be given considerable weight, 
since the investment fund carries its own expense loading separately. 
This method results in a higher loading on all policies issued at 
advanced ages, and also on the cheaper forms of policy, such as term 
policies, but this is deemed equitable in view of the fact that these 
are the types of policy on which the gains from favorable mortality 
experience are normally least. 

Participating policies regularly carry an excessive loading, intended 
to make certain the payment of dividends. The method used in 
determining the amount of this excess loading is of little importance 
to the policyholder, provided the method used in apportioning divi¬ 
dends is consistent with it. 

VII. DISBURSEMENT OF LIFE INSURANCE FUNDS 

The funds received by an insurance company from its policy¬ 
holders are disbursed in five principal ways. The first charge against 
them is of course the cost of doing business. A second principal class 
of expenditure is the payment of matured policies. A third is the 
payment of surrender values. A fourth is the making of loans to 
policyholders, and a fifth is the payment of dividends to stockholders 
and policyholders. 

Expense .—The expense item needs no special discussion. It 
includes commissions on new business and on renewals, expense 
of medical examination and the investigation of applications, the 
investigation of claims and the contesting of those whose character 
makes contest advisable, the control of investments, and the general 


LIFE INSURANCE 


259 


administrative and clerical costs. The heaviest costs are those 
involved in selling, in investigating applications, and in recording 
the issuance of policies. Usually, this initial expense amounts to 
75 or 80 per cent of the first year’s premium. 

Settlement of claims. —The disbursement of funds in payment of 
matured policies is not an expense but a return of capital to its owners. 
There is probably no large class of claims, with the exception of 
requests for withdrawal of bank deposits, which are settled with so 
little friction as the settlements made under life insurance policies. 
It is the policy of reputable companies to contest claims only in cases 
where there is fairly conclusive evidence that the company has no 
real liability. In the early days of insurance, some companies fol¬ 
lowed the policy of contesting claims on technical grounds, though 
this practice was probably more prevalent in fire than in life insurance. 
Such contests are expensive, partly because juries are apt to be preju¬ 
diced in favor of claimants, and judges interpret the contracts as 
strictly as possible against the companies, partly because of the 
adverse advertising which an insurance company gets from its contests. 

Optional settlements. —Most insurance policies provide for an 
optional settlement in the form either of a cash payment in full or of an 
annuity to the beneficiary. The instalment plan provides simply that 
the insurance company shall pay the amount of the insurance in, say, 
twenty instalments to the beneficiary or the beneficiary’s estate. 
In this case there is an allowance for interest which substantially 
increases the sum to be paid. 

The life annuity plan of settlement provides a payment of a certain 
sum per annum to the beneficiary for life. The amount of the annual 
payment, under this contract, depends upon the age of the beneficiary 
at the time the contract is taken out. 1 

A continuous instalment contract is a combination of the instalment 
and annuity plans, providing for the payment of the insurance in 
annual instalments over the life of the beneficiary, or for a specified 
term of years, whichever is the greater. 

Under all these instalment contracts, the beneficiary is relieved of 
the problem of investing the proceeds of the policy, and incidentally 
also of the payment of taxes upon such investments. The rate of 
interest allowed is not, by present standards, high, but the fact that 
the rate is guaranteed for a term running far into the future, the high 
degree of safety, and the relief of the beneficiary from responsibility 

1 For further discussion see pp. 276-80. 


26 o 


RISK AND RISK-BEARING 


go far to compensate for the moderate interest rate. Except in the 
cases where the proceeds of a cash settlement could advantageously 
be used to pay off existing indebtedness, some sort of annuity or instal¬ 
ment settlement is more likely than not to be of advantage. 

The following quotation emphasizes, but does not exaggerate, 
the advantages of the annuity as a method of settlement: 

There are two modes of settlement of a life insurance benefit at the 
death of the insured. The first is to pay down the whole sum at once; and 
this method has been followed, with only rare exceptions, since life insurance 
began. The second mode is to pay an annuity to the beneficiary for a 
certain period or for life; this has been the exception. But this latter plan 
received impetus through legislation in New York State in 1906, which 
included in a standard form of policy contract a privilege by which the 
insured during his life might elect to have the principal sum paid in periodical 
instalments after his death. Since then one after another of the American 
companies has issued policies containing on their face specific provision for 
the payment of the benefits in monthly instalments of selected amounts and 
for selected periods. 

Fire insurance on a merchandise stock is for the purpose of providing 
funds with which the stock, if burned, may be replaced without loss to the 
merchant. In this case, the sum to make replacement is required to be 
available immediately after loss by fire in order that new stock may be 
purchased and business resumed. But human life is different, it is in no 
sense possible of replacement except by in some manner arranging for a 
continuance of its income or productive value which would cease at death. 
And, moreover, the capitalized value of the life paid in one sum is not 
needed and cannot be used for the emergency called for by family insurance, 
except that it be invested to produce income. 

It is in the nature of things that humankind should be possessed of 
ungratified wants which more means would fill; it has been so since com¬ 
mencement of time; without this human trait material progress would 
cease. It is common in both man and woman; but possession of means 
earned by one’s self checks desires; unearned means fosters them; hence 
because man has more commonly been the earner and provider and woman 
the dependent and recipient, the trait is more pronounced in her. With 
the beneficiary of the small insurer it manifests itself in wish for better 
quality and make of articles of dress—in a new hat instead of one made 
over on last year’s frame; in small articles of personal adornment which 
have been promised since long ago but have never come. Yes, so many 
things are needed; it seems as though they had been accumulating since 
wedding day. And so they have; and so they will continue to do; for it 
is the rare nature of wants that their fulfilment gives birth to greater 
ones. 


i 


LIFE INSURANCE 


261 


Doubtless some beneficiaries under lump sum life insurance policies are 
endowed with a measure of mental and moral poise which no great calamity 
could overturn. But this cannot be known of a certainty as to any partic¬ 
ular one until the test is made. This one may possess the quality of self- 
denial in degree that would safely guard against use of the fund for unneces¬ 
sary self-expenditures; but this is only another way of describing her who 
has a good and charitable heart, for charity and self-denial go hand in hand. 
Caution would prevent bestowal of any portion of her insurance money in 
charity on strangers. Would it help if the supplicant were a relative ? 

All have poor relations; the insured may not have been able to help 
during his lifetime, but there is now a large sum of money in bank. It is 
not charity that is asked, merely a loan is wanted; and long before the 
money is needed it will be repaid, if all goes well. Shall it be refused ? 
No. Husband would give it if he were alive; he often said he would be 
glad to help if he could; but he never had so much money in bank without 
immediate use for it. Nay, this excuse would not be required; the money 
would be “loaned” in any event; for denial would be impossible to this 
kind-hearted woman with the means at hand. Nor would repeated requests 
of the same nature be denied if accompanied by valid or plausible reasons. 

Thus under lump sum policies have thousands of men unwittingly 
insured their lives in part for the benefit of needy relations and friends 
whom during lifetime they could not afford to assist. For unless he does 
help in the support of poor relations and friends during his lifetime, no man 
intentionally includes provision for them in his life insurance. If he does 
provide for them during life, then it is unfair to his beneficiary if he does 
not include account of them in his insurance. But if he cannot help them 
while living, it is unlikely that he can afford the high premium payments 
necessary to provide for them after death. 

The possession of a sum of ready money renders its owner liable to 
become the object of designing persons seeking dishonest advantage with 
plausible schemes dressed up as sound investments. The beneficiary is 
inexperienced in investments. Knowledge of this is not lost on promoters, 
and leads to her being sought out as an easy mark for their designs. No 
sooner does the fund reach her hands than skilled wits are placed in the 
balance against hers. With what result is well known; a woman unso¬ 
phisticated in sharp business practices is attacked by a swindler at a time 
when she is without defense, and imposed on and robbed. 

But assuming the investment to be a good one, still a difficulty and a 
danger remain. Will the income be sufficient to meet expenses? If not, 
then a part of the security must be disposed of from time to time to obtain 
principal to eke out living expenses. But this may not be necessary. Will 
the money be left invested? The security is transferable, and therefore 
salable; the better the value, the lower the interest; the lower the interest, 
the greater the temptation to sell and reinvest in something paying more; 


262 


RISK AND RISK-BEARING 


and the higher the interest, the less the value, and the more danger of loss 
of interest, or of both principal and interest. It may be borrowed upon any 
day. It is an object of taxation. It is subject to attachment. And 
finally, no matter how high the rate, the interest income from the invest¬ 
ment will be equivalent to a low rate on the whole amount received from 
the insurance company, because it is unlikely that all of the insurance 
money will be invested. 

These modes of paying the benefit may be had in any form of policy— 
Term, Whole Life, Limited Payment Life or Endowment. It costs nothing 
extra; the premium charged is exactly proportionate to that for a policy 
providing for an equivalent single sum benefit. The company acts as 
trustee and pays out to the beneficiary the sums provided, in amount and 
in time approximating the manner in which the income of the insured was 
received during life. At the death of the insured the financial result is 
the same as if the discounted value of the unpaid instalment benefits pro¬ 
vided for became automatically invested at 3! per cent compound interest; 
and future payments continue to earn and compound at the interest rate 
until all of both principal and compounded interest is paid as provided. 
Thus, for example: in a policy providing for $50 per month for forty years 
the discounted value of the future benefits to be paid is $13,089, and it is 
on this sum that the insurance premium is charged; but the total sum 
guaranteed to be paid over forty years is $24,000, or $13,089 of principal 
and $10,911 of accumulated interest. 

A life insurance benefit left in this manner can be used only for the 
purpose intended: namely, for the necessities of life and to keep home 
together. It cannot be sold or borrowed upon, because it is not transferable. 
It can be attached for debt only if contracted for the necessaries of life. 
It is free from taxation and charges of fees of any kind whatsoever; and 
finally, the law prohibits the company from discounting and paying the 
amount in one sum to the beneficiary upon her request unless the insured 
so consented during his life. 1 

The continuous instalment is particularly advantageous in cases 
where the insured desires to provide an income for a widow for life 
and for children for the period of their minority. The life annuity 
feature insures an income to the widow throughout her life, while 
the “continuous” feature provides that in case of her early death the 
payments will be continued for a term of years sufficient to bring the 
youngest child to the age of self-support. 

Surrender values are now a regular feature of practically all 
life policies written by legal reserve companies, except term policies. 
During the early history of life insurance, it was quite commonly 

1 From an anonymous pamphlet, Luxuries or Necessities. 


LIFE INSURANCE 


263 


true that a policyholder who failed to keep up his premium payments 
forfeited all his rights under the policy. Such a practice, however, 
was obviously unfair to the holders of the higher-priced policies, such 
as endowment policies, for the man who lapses after carrying a high 
premium policy for a number of years has paid much more than the 
man who has been carrying whole life or term insurance, and has 
received no more in return. The issuance of policies containing a 
provision for surrender value began in the late fifties, and in 1861 
Massachussetts passed the first non-forfeiture law. Similar laws 
have since been enacted by most states. 

The provisions regarding surrender relate, first, to the length of 
time a policy must be carried before any surrender value accrues; 
second, to the amount of such surrender value; third, to the manner 
in which it shall be paid. In most cases there is no surrender value 
till the third or fourth year, though some grant it in the second year. 
From what has been said above concerning the excessive proportion 
of the expenses which attach themselves to the first policy year, it is 
obvious that a company cannot afford to grant liberal surrender 
values till a sufficient number of premiums have been paid to compen¬ 
sate it for this expense. 

From the third year to a later date, varying from the fifth to the 
fifteenth year, the surrender value consists of the legal reserve minus 
a surrender charge which gradually decreases as the policy grows 
older, and in no case, with most companies, exceeds 2\ per cent of 
the face of the policy. The tendency both of legislation and of com¬ 
petition between insurance companies has been to increase the liber¬ 
ality of the surrender values, and the popularity of these provisions 
is evidenced by the fact that from one-fourth to one-third of the 
policies terminated are surrenders and lapses. 1 

Three methods of payment of the surrender value are generally 
provided: cash settlement, extended insurance, and paid-up insurance. 
Under the extended insurance plan, the policy continues in force for a 
limited period; under the paid-up insurance settlement, the face of 
the policy is reduced and the policy remains in force throughout the 
life of the insured. Under both the extended insurance plan and the 
paid-up insurance plan, the amount of insurance is such as the cash 
surrender value will purchase as a single net premium. If the insured 

1 The statement is perhaps too sweeping, as a very large proportion of the 
lapses occur in the first or second year, before the liberality of the surrender pro¬ 
visions is a factor. 


264 


RISK AND RISK-BEARING * 


indicates no option, but simply stops paying premiums, the extended 
insurance plan is applied automatically. At the close of the extended 
insurance period, the company, before closing the account, must 
obtain evidence that the insured is still living. As the beneficiaries 
of lapsed policies are frequently ignorant of the existence of the 
extended insurance, which may run for many years, there is often no 
small difficulty in determining whether liability actually exists. 

Another method of handling lapsed policies has recently been 
introduced—the automatic premium loan. Under this plan, the 
cash surrender value is applied as a series of loans to meet successive 
premium payments, and the policy is kept in force till the cash value 
is exhausted. The advantage of this plan over the extended insurance 
plan, to which it is very similar in effect, is that under the premium 
loan plan the policy does not technically lapse, so that the insured 
retains the right to reinstate himself by paying the back premiums, 
with interest, without medical examination. On the other hand, the 
policy expires somewhat sooner under this plan, as 5 or 6 per cent 
interest is charged against the premium loan, while the reserve is 
accumulating interest at the rate of only 3 or 3J per cent. 

Policy loans .—While the making of loans on the security of policies 
is not theoretically a method of disbursing funds except for temporary 
purposes, in practice a large proportion of the accumulated reserve 
is actually returned to policyholders, through loans which stand as 
permanent obligations of the policyholders and are deducted from the 
face of the policy at maturity. From the standpoint of an insurance 
company, a loan made to a policyholder and secured by his policy, 
provides an investment in most respects ideal. There is no cost for 
investigation of the application, or for collection, and there is no risk, 
for the applicant is borrowing only his own funds, and can never 
secure a loan in excess of the surrender value of his contract. More¬ 
over, the rate of interest charged on policy loans is higher than that 
obtainable in most years upon safest investments, though this is not 
necessarily true in the years of high interest rates when the largest 
volume of policy loans are made. 

From the standpoint of the company, there are two objections to 
policy loans. In the first place, the loan privilege creates some risk 
of embarrassment through an excessive number of demands for loans 
at the same time. With the present almost universal acceptance of 
the principle of making loans on demand up to the full cash surrender 
value of the policy, the risk of a run on the reserves of insurance 


LIFE INSURANCE 


265 


companies, in time of financial crisis, is not negligible. Some authori¬ 
ties are inclined to regard this as a serious objection to the extension 
of the loan privilege, though no trouble has yet resulted from it. 
Upon the whole, the risk seems much less serious in the case of insur¬ 
ance companies than is the similar risk in the case of savings banks, 
and the experience of the latter indicates that the danger is not suffi¬ 
cient to justify the abandonment of such a profitable field of invest¬ 
ment. 

The other objection to policy loans, more serious from the stand¬ 
point of insurance administration, is the fact that the issuance of policy 
loans has a marked influence in increasing the lapse rate. The reasons 
for this tendency will be made clearer by an examination of the 
advantages and disadvantages of the policy loan from the standpoint 
of the policyholder. 

Policy loans are usually taken out under one of two conditions: 
either the insured resorts to the company as a source of temporary 
accommodation to meet some special need or else he secures capital 
for permanent investment, or for the retirement of debts elsewhere, 
by contracting a loan which he has little or no intention, at least no 
prospect, of repaying. 

The first class of loans are sound financial operations. If an 
individual is going to borrow the money somewhere anyway, the 
reserve on his life insurance policy offers several advantages. The 
insured can secure the loan on demand without any investigation of 
his credit standing, and he will not be interrogated as to the purpose 
for which he intends to use the money. Moreover, after the first 
six months he can pay off his loan at any time, without loss of interest, 
and the rate charged is usually lower than the rate he would pay at 
his bank. 

Comparatively few policy loans, however, are of this type. It 
is stated in fact that only 8 per cent of policy loans are ever repaid 
before the maturity of the policy. 1 Most students of the question 

1 Riegel and Loman, Principles of Insurance, p. 107. 

seem to agree that such permanent policy loans are objectionable 
from the standpoint of the real interests of the borrower. The follow¬ 
ing statement from a prominent insurance company official is typical 
of the opinion generally expressed on this question, both by insurance 
company officials and by academic students of insurance theory: 

The policyholder’s privilege of borrowing a portion of his reserves on 
the security of his insurance contract was a development of competition, 


266 


RISK AND RISK-BEARING 


and like the giving of surrender values, the idea grew and the original 
privilege was extended until the plan became permanently fixed upon the 
business by being made a requirement of the law. 

As originally intended, this privilege would have been a great service to 
the policyholder and to the companies as an attractive feature or induce¬ 
ment to insure, but as in the case of surrender values, the loan privilege has 
been carried to extremes, the general practice now being to loan, as well as 
to pay as a cash value, the full reserve upon a policy after the tenth year of 
insurance. 

The primary purpose of this law, which fastens a banking function upon 
life insurance, was to enable the policyholder to have the use of his reserves 
in time of financial stress. It was believed that this would be of great 
value in preventing lapses by permitting the insured to apply his reserves 
to the payment of premiums when short of cash, and that the plan in 
general would prove an attractive one as an inducement to the taking of 
insurance. 

These advantages are freely conceded, but experience has demonstrated 
that they have been largely neutralized by the disadvantages and the 
abuses which have resulted from the expansion of this loan privilege. These 
loans operate directly against the beneficiary by reducing the protection, 
for only a small per cent of the loans are repaid by the borrowers and the 
rest must be deducted from the claims at death or from surrender values. 
They also encourage lapsing by the additional burden placed upon the 
policyholder. Many borrowers, finding their protection reduced, their 
premiums remaining the same and an annual interest charge to pay, become 
discouraged and lapse or abandon their policies. An injustice is also done 
the remaining policyholders by the low withdrawal charge and the possible 
danger of a “run” on reserves in time of panic. Broadly speaking, the 
policy loan privilege discourages saving and encourages spending. 

Ratio of Loans 


Year to Reserves 

(Per Cent) 

1890. 2.97 

1895. 3-62 

1900. 6.13 

1905. 9-83 

1910. 15-35 

1915. 17.86 


Those who borrow on their policies are not satisfied with small amounts. 
They are tempted to withdraw all the money they can get, and having 
gotten it, they are tempted to spend it for pleasure or to risk it in business 
or speculative ventures. The result is that a temporary loan develops 
into a permanent obligation, and the idea of repaying it is abandoned. 
Consequently when death comes the widow finds that her life insurance 








LIFE INSURANCE 267 

has been materially reduced and then bitter disappointment and some¬ 
times misery and hardship follow. 

It is not surprising, therefore, that the practice of borrowing on policies 
has come to be known as borrowing from the widow and orphan. No con¬ 
cession ever granted to policyholders has operated so greatly to the dis¬ 
advantage of beneficiaries. 

One class of loans—those taken out on policies issued for the protection 
of business ventures or for purely commercial purposes—are justifiable; 
they are serving a purpose for which the contract was entered into. But 
one cannot view with equanimity the taking of loans on policies issued for 
family protection, and unfortunately the greater number of loans are taken 
on this class of policies. 1 

The case presented against the policy loan is forceful, but in the 
author’s opinion not convincing. Let us examine it more closely. 
In the first place, the characterization of insurance borrowing as 
borrowing from the widow and the orphan, which is a standard point 
in the case against policy loans, carries with it an implication that 
borrowing from some other source would not have the same effect 
on the financial status of the widow and the orphan. It is obvious 
that if the policyholder borrows from some other source, and the debt 
remains unpaid at the time of his death, it will operate to reduce his 
estate just as the policy loan operates to reduce the face of his policy. 
Assuming that the beneficiaries are the heirs, the only case where they 
benefit from placing the loan somewhere else, rather than with the 
insurance company, is the case where the widow and the orphan 
desire to evade the payment of the debt, and the estate, aside from 
insurance, is not large enough to cover it. The proceeds of insurance 
policies, so long as they are kept intact, are in most states exempt 
from the claims of all creditors except the insurance company. Hence, 
whoever desires to borrow in such a way that his heirs may be able 
to evade the payment should avoid the policy loan. Such cases, 
however, are not particularly frequent, and ought not to work a 
condemnation of the loan privilege. The real test of the desirability 
of contracting a loan is not the source from which the funds are 
obtained but the purposes for which they are used. If the money 
is used to invest wisely in a home, in the reduction of existing indebted¬ 
ness, or for safe investment elsewhere at a higher rate of return than 
the interest charged by the insurance company, there is no reason 
why the reserve should not be borrowed. 

1 Adapted by permission from J. B. Lunger, “The Problem of Cash Surrender 
and Loan Values,” Annals of the American Academy of Political and Social Science , 
LXX (March, 1917), 54 ~ 5 8 - 


268 


RISK AND RISK-BEARING 


The real objection to policy loans, aside from an ancient objection 
to all borrowing, which seems to be nearly obsolete except as it appears 
in discussions of this particular question, lies in the fact that such loans 
are expensive. The money which the policyholder borrows from the 
company at 5 or 6 per cent is the same money which he is loaning to 
the company at 3 or 3I per cent. To make the case concrete, let us 
examine the case of an individual who is carrying a whole life policy, 
premium $15.63, on which he has made twenty payments. His 
loan value is $230.50. If he is to borrow that amount of money at 
all, he probably cannot do better than to borrow it from the insurance 
company. If he does so, however, and pays 6 per cent interest, he 
begins at once to pay $29.46 per annum for $769.50 insurance. If 
he is still a good insurable risk, it will pay him better to let his policy 
lapse, take the cash surrender value, and take out a new whole life 
policy for $1,000 at a premium, of say, $30.05, thus gaining $230.50 
additional protection for 59 cents additional annual cost. 1 A recog¬ 
nition of the relatively expensive character of the protection afforded 
by policies on which the reserves have been borrowed must be a 
fundamental reason for the high lapse rate among borrowers. 

The borrowing transaction does not, however, create the unfavor¬ 
able financial situation in which the borrower finds himself. It merely 
calls attention to it. If the policyholder in our illustration does not 
borrow on his policy at all, but merely keeps it in force, he still pays, 
not $15.63 for $1,000 insurance, as he doubtless believes, but $15.63 

1 The rates used in the illustration are those charged by a well-known company. 
A similar calculation for the tenth year of the life of the same policy shows a gain 
of $98 in protection and an actual reduction of 93 cents in annual cost from lapse 
and reinsurance as compared with borrowing the reserve at 6 per cent. Like 
calculations using the rates of three other companies show the following results: 
Lapse and reinsurance at the end of ten years, as compared with permanent bor¬ 
rowing of the reserve, results in a reduction of annual cost of 96 cents in company A, 
74 cents in company B, and $1.04 in company C, with a gain in protection of $98 
in each case. At the end of twenty years, lapse and reinsurance give an added 
cost of 80 cents in company A, 97 cents in company B, and $4.23 in company C, 
for which $230.50 additional protection is obtained. In this calculation, reserves 
have been figured on the basis of 3 per cent; if they are figured at per cent the 
gain from lapse and reinsurance is slightly increased. If policy loans are figured 
at 5 per cent, the gain from lapse is much less, but in most cases is still apparent. 
The foregoing calculations are all for non-participating policies; in the case of 
participating policies, the calculation is much more complicated and involves a 
large element of approximation. On account of the practice of paying increased 
dividends on older policies, it is probable that in most cases permanent borrowing 
on participating policies is cheaper than lapse and reinsurance. 


LIFE INSURANCE 


269 


plus the income he could secure from $230.50 for $769.50 of insurance. 
For the individual who has become uninsurable since he took out his 
original policy, such a contract may be very favorable, but for the 
good risk it is much less favorable than it appears. 

The reason for this tendency of an insurance policy to become more 
and more expensive, so far as its real insurance features are concerned, 
is primarily the fact that the longer one carries his policy, the large 
the fund which he has accumulated and on which he is receiving only 
savings bank interest. The man who is borrowing at 6 per cent, 
from any source, cannot afford to invest at 3I per cent. 

All this fortifies the contention of a previous section, that renew¬ 
able term insurance, first, when obtainable, and next to that whole 
life insurance, are the most economical and logical types of insurance 
from the standpoint of the policyholder, except in those cases where 
the mild degree of compulsion afforded by the insurance contract 
enables a policyholder to save what he would otherwise squander. 

VIII. SPECIAL TYPES OE LIFE INSURANCE 

Group insurance .—One of the newest developments in life insur¬ 
ance is the group policy. This is a term policy written on the lives 
of a large number of individuals, employees of a single firm, and paid 
for by the employer. The typical provisions of such a contract are: 

1. No medical examination is required, except when the number of 
employees is small. Reliance is placed on the operation of the law of 
large numbers to secure a normal mortality experience, while the 
character of the group is usually such as to protect the insurer against 
the adverse selection, which would be likely to result from the omission 
of medical selection on ordinary life policies. A group of from fifty 
to a hundred fives is considered sufficient to insure working of the 
law of averages. 

2. The policy is taken out by the employer; the premiums are 
paid by him; but the proceeds are payable to the heirs of the insured 
employees, either directly or through the employer. 

3. Each policy is written as the result of a special investigation. 
The rate charged depends on such factors as the age distribution of 
the insured; 1 the proportion of women employees, the standard of 
living; the occupational risk of injury or disease; and similar factors. 

1 Not simply the average age. Examination of the mortality table will show 
that two groups of the same average age, but having differing proportions of persons 
of very advanced and early age, will show very different mortality rates during 
the life of a short term policy. 


270 


RISK AND RISK-BEARING 


4. New employees ordinarily come under the protection of the 
policy automatically, under specified conditions, the premium rate 
being adjusted from month to month as the hazard changes. 

5. Employees severing their connection with the organization 
automatically lose the protection of the policy, unless the employer 
chooses to continue paying premiums to maintain insurance on the 
lives of employees during temporary lay-offs. In some cases the 
employee is given the privilege of retaining protection by assuming 
responsibility for payment of premiums at a rate appropriate for his 
age. Returns of unearned premium, without surrender charge, are 
made in cases where the liability of the insuring company is reduced 
through the separation of employees from the pay-roll. 

6. Several methods of determining the amount of liability are 
in use. The following alternatives are suggested by one insurance 
company which has been a leader in the development of group insur¬ 
ance: 

1. The same amount of insurance for all employees, such as $500, 
given either immediately on employment or after a waiting period, such as 
six months or one year. 

2. An amount equal to the annual wage of an employee or some per¬ 
centage thereof. 

3. An amount to be based on length of employment, such as an initial 
amount of $500 after one year of employment and adding thereto $100 for 
each additional year of service until a maximum of some fixed amount has 
been attained, such as $1,000 or $1,500. Any other plan or formula which 
meets conditions more favorably than those suggested, may be adopted. 1 

7. Provision is frequently made that the policy shall mature 
immediately as to any employee who becomes totally and permanently 
disabled. In such cases it is customary to provide for the payment of 
the insurance in instalments. 

The primary purpose of group insurance is to increase employees’ 
good will toward the organization which they serve, thereby reducing 
labor turnover and adding to the efficiency of the individual laborers. 
It is believed that in many cases money expended in paying premiums 
on a group policy will buy more added productive effort than will a 
similar amount of money spent for the same purpose through increased 
wages. It is also argued that an insurance policy will serve as an 
especially attractive feature of the service in the case of married 

1 From an analysis of group insurance published by the Travelers’ Insurance 
Company. 


< 


LIFE INSURANCE 




271 


employees and, in general, among the steadier class of workers whose 
continuous services it is especially important to retain. 

So far as the insurance features of the group insurance plan are 
concerned, the device seems so far to have been eminently successful. 
The elimination of medical examination, the small amount of work 
connected with the issuance and recording of policies, the simplifica¬ 
tion of collections, and the lowered commissions which may properly 
be paid to agents for selling insurance on the wholesale plan, combine 
to make this an especially economical and at the same time profitable 
type of insurance. Whether the plan has been equally successful as a 
device for improving the relations of employers and employees is 
uncertain. The question is at best a difficult one to answer accurately, 
and the period during which group insurance has been in vogue is so 
short, and labor conditions have been so unstable during that period, 
that no real test can as yet be said to have occurred. 

Industrial insurance .—Another type of insurance which deserves 
particular mention is the so-called industrial policy. This is a policy 
for a small amount, usually less than $500, on which the premiums 
are collected weekly by a house-to-house canvasser, instead of being 
mailed to an agent of the company, as is the practice with most 
forms of life insurance. The amount of the premium, instead of the 
face of the policy, is stated in round numbers, the most frequent unit 
being five or ten cents per week. The term “industrial” is applied 
to these policies not because they have any connection with industry 
but because the greater number of such policies are sold to wage¬ 
workers. Such policies are regularly written on the lives of children 
as well as of adults, the object being to provide for the expenses of last 
sickness and burial. For this purpose such insurance performs a 
useful service. 

The chief objection to the industrial policy is its high cost, the 
premium usually working out about double the cost of whole life 
insurance of the ordinary type. No cash surrender or loan value is 
usually allowed, until the policy has run for a very long period, but 
paid-up insurance for a portion of the face is allowed in cases where 
the policy has been carried for a few years. 

The high cost of this type of insurance is due primarily to the 
excessive cost of collection. Another reason is found in the high 
lapse rate, which makes the selling cost greater than would be the 
case if the policy once placed did not so frequently have to be replaced 
by another in order to keep the volume of business constant. A third 


272 


RISK AND RISK-BEARING 


reason for the high cost is found in the mortality rate, which is con¬ 
siderably higher than is the case with ordinary policies, partly on 
account of a somewhat higher normal death-rate in the class of the 
population who make up the bulk of the policyholders, and partly 
on account of the lack of medical examination. Formerly it was the 
practice to require a very superficial examination by a physician, but 
the present practice, so far as policies of less than $500 are concerned, 
is to place on the agent the responsibility of inspecting the candidate 
and certifying to his apparent good health. Naturally, this method 
leaves opportunity for rather more adverse selection than is possible 
where regular medical examination is required, though the difference 
is less than might readily be anticipated. 

Fraternal insurance .—One of the most interesting developments 
in American life insurance is the insurance written by the various fra¬ 
ternal orders, beginning with the organization of the Ancient Order of 
United Workmen, in 1868. The original idea underlying the work of 
these companies was to make insurance incidental to the operation 
of a system organized primarily for the purposes of mutual assistance 
and social intercourse within a selected circle. Insurance of this 
sort characterized the medieval guilds, and has frequently been 
written as incidental to organizations formed for other purposes. 
In the case of the fraternal orders, however, the insurance feature has 
proved so popular as to overshadow the social side of many of the 
organizations, so that they have become insurance societies with a 
fraternal feature rather than fraternal societies with an insurance 
feature. This development indirectly led, in many cases, to the under¬ 
mining of the insurance feature itself. The original plan was a straight 
assessment plan, each member paying his share of the sum due to the 
relatives of the deceased. Such a system can be worked successfully 
with a cost very much lower than the rates charged by legal reserve 
companies for “old line” insurance, provided the membership remains 
from year to year of the same fairly low average age. In a labor 
union, for example, the tendency is for the older members to drop 
out of the organization and be replaced from year to year by young 
men, so that the average age and the average mortality remain 
unchanged. Assessment societies among the employees of corpora¬ 
tions have operated very successfully, the tendency being here also 
for the older members to drop out of employment, so that the mor¬ 
tality is the relatively low mortality of people who are able to stay on 
the pay-roll. 


LIFE INSURANCE 


273 


In the fraternal insurance society, on the other hand, there is 
just the opposite tendency. The older the member gets, the less 
likely he is to drop out. As a result, the average age increases and the 
assessments grow heavier. As the assessments grow heavier, it 
becomes more difficult to secure young members, the younger men 
finding it more advantageous to go into newer societies with a lower 
assessment rate. As soon as the younger members stop coming in, 
the death of the organization, so far as its insurance features are con¬ 
cerned, becomes merely a matter of time. As each member dies, a 
larger assessment on the remaining members is necessary until, if 
the plan were carried through to the end, the last surviving member 
would have to pay the entire face of the policy of the next to the last 
member, and would then be left himself without insurance. Long 
before this contingency arises, however, assessment orders cease to 
function. 

As the weakness of assessment insurance became apparent in the 
eighties and early nineties, the stronger fraternal orders shifted from the 
straight assessment plan to the graded assessment, a plan under which 
the assessment varies with the age of the member at entrance. Such 
a plan is theoretically workable, but in practice has not proved much 
more stable than the original flat assessment, for the reason that the 
assessments have not been large enough to provide adequate reserves 
and the lack of reserves has made it necessary to increase the number 
of assessments as the orders grow older, so that the same tendency 
for younger men to drop out and older men to stay in has appeared. 

Since about 1910, the weakness of the ordinary type of fraternal 
insurance without adequate reserves has become so apparent that 
there has been a general movement to reorganize the fraternals on a 
“legal reserve” basis. The reorganization has involved the adoption 
by the fraternal companies of the fundamental actuarial principles, 
which we have seen above applied to ordinary commercial insurance. 
A fully reorganized fraternal society with adequate reserves differs 
from an “old line” company only in the following respects: 

First, the fraternal companies use their own mortality table, 
which shows a somewhat lower mortality and is probably considerably 
more accurate than that used by the old line companies. 

Second, the interest allowance is figured in some cases at 4 per cent. 

Third, the government of a fraternal order is much more demo¬ 
cratic than that of an old line company, even though the latter be 
mutual in character. 


274 


RISK AND RISK-BEARING 


( 


A considerable proportion of the members take some part, as a 
rule, in shaping the policies of the order. From the local unit, the 
lodge, delegates are sent to district, state, and national conventions, 
and important matters of policy are settled directly by these national 
conventions. Fraternal newspapers do much to create an effective 
public opinion among the members. 

Fourth, the expense loading in the premiums is very low, though 
not as low as in a few of the old line companies. The actual expenses 
of the fraternal organization are almost invariably lower. This is 
partly because, in line with democratic precedent, it is their custom 
to pay relatively small salaries to their officers, and partly because 
the fraternal features have enabled them to keep their selling costs 
very low, a large part of their publicity being secured by the unpaid 
work of the membership. 

In the early history of the fraternal orders there were no paid agents 
at all, but more recently there has arisen a system whereby “deputies” 
are paid small commissions to visit the local lodges and put on cam¬ 
paigns for new members. Their commissions, however, can be kept 
relatively small because, whereas the agent for an old line company 
has to find his own prospects and close his own sales, the fraternal 
deputy operates by stirring up the enthusiasm of the members and 
getting them to do much of the work, often through the medium of 
contests between neighboring lodges, or between picked teams in the 
same lodge. 

Fifth, fraternal insurance certificates carry, as a rule, no cash 
surrender value and no loan value. 

Sixth, a fraternal insurance certificate is not a contract whereby 
the order promises to furnish a given amount of insurance for a stipu¬ 
lated sum. The rates are always subject to readjustment by action 
of the order, and the amounts payable may be scaled down in case the 
order is unable to pay the full amount. Hence, it is almost impossible 
for a fraternal order to become technically bankrupt. Its liabilities 
consist only of its matured claims. 

Seventh, the beneficiary has no legal equity in a contract of fra¬ 
ternal insurance. The insured can change the beneficiary at any 
time, although as a rule he cannot insure in favor of anyone except a 
dependent. The beneficiary cannot sell, assign, or transfer his claim 
prior to the death of the insured, because he has no legal claim to 
transfer, nor can a legal equity be created by the payment of premiums 
by the beneficiary. 


LIFE INSURANCE 


2 75 ' 


Fraternal insurance has been looked upon with disfavor by most 
insurance authorities in this country, chiefly because of the unsound 
actuarial practices with which it has so frequently been associated. 
Nevertheless, it has rendered a very large service and in the author’s 
opinion is worthy of a better rating than it generally gets. Fraternal 
insurance frequently gets a “black eye” in a community, because of 
the experience of members who after paying insurance for twenty- 
five or thirty years and becoming too old to secure insurance elsewhere, 
and after having their rates raised to two or four times their previous 
levels, have been compelled to drop their policies. What is overlooked 
in these cases is that the individuals in question have really had very 
cheap protection during the productive period of their lives, and if they 
had bought the insurance as term insurance, would have had no reason 
to be dissatisfied with their bargains. An individual who gets less 
than he bargained for, even though he gets as much as he paid for, is 
likely to express discontent, and this has very frequently been the 
situation of the buyer of fraternal insurance. 

The history of the fraternal movement in this country can never 
be understood if it is viewed merely as a phase of the history of life 
insurance. It is a part of the great social democratic movement of the 
late nineteenth century of which the Greenbackers, the Farmers 
Alliance, the Populist party, the Free Silver movement, the United 
States Grain Growers, Incorporated, and the Non-Partisan League 
are more conspicuous manifestations. The fraternal insurance 
enthusiast of the eighties and nineties’was an apostle of freedom, an 
advocate of the rights of the downtrodden masses against the greedy 
barons of Wall Street. The enthusiasm with which the fraternal 
organizers of that early day denounced the practices of the old line 
life insurance companies amounted almost to a religious faith. In the 
thought of these apostles, mortality tables, compound interest calcula¬ 
tions, legal reserves, were implements of darkness, designed to separate 
the trusting citizen from his money and place it at the disposal of the 
stock manipulators and trust magnates of the East. As these devices 
have become better understood, the ardor of the crusaders for their 
abolition has waned. 

In any evaluation of fraternal insurance, the value of the social 
features must not be overlooked. As noted above, fraternal insurance 
has been sold at a low figure because, among other reasons, the 
membership as individuals have carried the selling costs. This 
method of propagating the order has been possible only because the 


I 


' 276 RISK AND RISK-BEARING 

local lodge and, to a less extent, the larger organization, have supplied 
a real social need. 

In every small community in the country, particularly before the 
advent of the r< movie,” the lodge furnished for many men the only 
excuse for staying away from home. The ritual of the order has often 
been elaborate; its mastery has supplied a stimulating exercise, and 
the opportunity for a genuine intellectual triumph, while the holding 
of office in a fraternal order has furnished an opportunity for self- 
expression and an object of ambition. The opportunity to wear a 
resplendent uniform, to appear in pomp at the funeral of a deceased 
brother, the winning of a banner for surpassing neighboring lodges 
in the percentage of members who appear in procession at an annual 
county rally, and the gaining of a free oyster supper by beating a 
rival team in a contest in securing new members—all these activities 
minister to genuine human wants, and because this is true the orders 
have been able to propagate themselves without expensive selling 
organizations and to furnish insurance at a minimum cost. 

Life annuities .—The life annuity is a contract designed to afford 
protection against the hazard of the individuals’ outliving their pro¬ 
ductive capacity and becoming a burden upon the community. In 
many respects this type of contract is exactly the reverse of the insur¬ 
ance contract. Just as the insurance policy insures against the 
financial loss due to premature death, the annuity policy insures 
against loss due to prolongation of one’s existence beyond his earning 
period. Insurance policies are usually paid for in annual instalments 
and mature in one lump sum, while the annuity is paid for in a lump 
sum and matures in a series of annual instalments. No medical 
examination is necessary for an annuity, as the only adverse selection, 
from the company’s standpoint, is that arising from the tendency 
of persons who anticipate long life to purchase annuities, rather than 
persons who know themselves to be in doubtful health. If it were 
feasible, it would be logical to establish medical selection to eliminate 
the abnormally good risks, but abnormalities in the direction of a 
tendency to excessive length of life are not readily identified. The 
inaccuracy of the mortality table to which reference was made on 
page 249, which works in favor of the company in ordinary life insur¬ 
ance, would work against it in writing annuities, hence a separate 
mortality table is used for this purpose. 

The computation of annuity premiums is similar to the computa¬ 
tion of insurance premiums and needs no extended discussion. The 


LIFE INSURANCE 


277 


present worth of the sums to be paid to the various members of a 
typical group, as shown by the mortality table, is divided by the 
number of individuals in the group, to get the net single premium for 
the policy, and loading is then added just as in the case of life insur¬ 
ance. The uses and the characteristic features of life annuities are 
brought out with such fulness in the following account that little 
further discussion is necessary: 

The primary function of the life annuity is to insure that a given sum 
of money will produce a life income larger in amount than could be safely 
secured through the channels of ordinary investment. The regular life 
annuity contract is a promise to pay, in consideration of a single cash sum, 
a fixed amount periodically during the lifetime of a designated person, 
called the annuitant. Annuities in practice are paid yearly, half-yearly, 
quarterly or monthly. 

The correct method of computing annuity premiums is essentially as 
follows: The mortality table, upon which the computation is based, con¬ 
sists fundamentally of a series of numbers, showing how many persons out 
of a given number alive at the youngest age in the table, survive to each 
age throughout the possible range of life. Given, therefore, a large group 
of persons all of the same age, the mortality table renders it possible to 
forecast how many of the group will be alive one year hence, two years 
hence, three years hence, and so on until all of the members of the group 
have passed away. If, therefore, a promise should be made to pay a yearly 
annuity of a dollar to each member of the original group, it could be fore¬ 
told how much would have to be paid at the end of the first year to those 
surviving at that time, how much would have to be paid at the end of the 
second year and at the end of the third year, and so on throughout the 
number of years covering the possible span of life of any of the members 
of the group. This series of payments may be compared to a serial bond 
issue maturing in definite amount throughout a period of years. And just 
as the banking house computes the present value of the principal payments 
under the serial bond issue, so the actuary computes the present value of 
the series of annuity payments that will be made to the members of the 
annuity group. Dividing the present value of the complete series of future 
annuity payments, by the original number of members of the group, he 
arrives at the true present value of the life annuity on the basis of the 
mortality table employed and of the rate of interest assumed in determining 
the present value of the future payments. 1 

A casual inspection of the table on page 278 explains at once why it is 
that few annuities are sold at the younger ages. The percentage return at 

1 In practice, this extended method of computation is not actually required, 
since mathematical short cuts have been developed which greatly facilitate the 
actuarial calculation. The final results of the short method, however, are identical 
with those obtained by the extended process described. 


278 


RISK AND RISK-BEARING 


these ages is not sufficiently in excess of the return upon funds invested 
through the regular channels to induce prospective annuitants to hazard 
the loss of a considerable portion of their principal by investing in an annuity. 
At the older ages, however, where the return exceeds say 8 per cent, the 
annuity makes its greatest appeal. In no other manner can a sum of money 
be invested to yield an absolutely certain life income of so large an amount. 

TABLE SHOWING COMPARATIVE RETURNS ON MALE AND FEMALE 
ANNUITIES, AVERAGE OF IS AMERICAN COMPANIES 


Age 


Male 

Female 

15 American 
Companies 

15 British 
Companies 

15 American 
Companies 

15 British 
Companies 



Lowest 

5-40 

5 - 4 i 

529 

5-21 

40. 


Average 

5.83% 

5-88% 

5-53% 

5-56% 



Highest 

6.29 

6.21 

6.08 

5.85 

• 


Lowest 

6-57 

6.61 

6.22 

6.13 

So. 


Average 

7 03% 

7-14% 

6-51% 

6-59% 



Highest 

7-SS 

7.46 

7.07 

6.82 



Lowest 

8.55 

8.75 

7.89 

7.78 

60. 


Average 

9-21% 

9-4i% 

8.31% 

8.36% 



Highest 

9.87 

9-63 

8.83 

8.58 



Lowest 

11.91 

12.80 

II -39 

11 33 

70 . 

- 

Average 

13-27% 

13-73% 

11.94% 

12.14% 



Highest 

13-85 

14.00 

12.47 

12.3S 



Lowest 

17.76 


l6 .57 


80. 


Average 

19 ■ ?f% 


17 .60% 




Highest 

22.47 


20.20 



Annuities have reached their greatest development in older, longer 
established countries where there are large accumulations of capital and 
where interest rates are relatively low. Pioneer countries, where available 
capital is urgently needed for development of their resources and where 
the return upon investments is correspondingly large, know little of annuities. 
For this reason, America has had less experience with annuities than has 
Great Britain. 

An important, but less well known, application of the annuity is to the 
problem of liberating for the urgent needs of the present capital that would 
otherwise be held invested because of the income it produces. An excellent 
example taken from the literature of a company that has made a specialty 
of the annuity business will serve to make this application clear: . 

A father, 69 years of age, had two sons, one a lawyer, age 27, and the 
other a doctor, age 29. Each was struggling to build up a practice in 
London. The father realized that his boys were then more in need of 
financial assistance than they were likely to be in later years after he had 
passed away. His income, about £400 a year, derived from investment 
of £12,000, was just sufficient to meet his own requirements. If he gave 
his sons any of the capital he reduced his own income. He solved the 






























LIFE INSURANCE 


279 


difficulty by purchasing an annuity of £400 payable £100 a quarter. This 
cost him about £3,184 of his capital. The balance of £8,816 he equally 
divided between his sons, enabling the doctor to move to Harley Street, 
and the lawyer to secure a remunerative partnership. 

The deferred annuity .—An annuity of much value is the deferred annuity. 
The first payment under this annuity is deferred for a period of years, say 
to the end of the annuitant’s income-earning period. It may be purchased 
by a single premium or by a series of premiums. Upon the death of the 
annuitant the contract terminates. For an additional premium, provision 
may be made for the return, upon the death of the annuitant, of such part 
of the premiums as may not have been returned in annuity payments. 

The deferred annuity is particularly adapted to men and women, 
without present or prospective dependents, who desire to provide during 
their income-earning period against possible dependency in old age. There 
is no more economical manner in which this provision may be made; though 
it is essential if there be dependents, that the deferred annuity should be 
supplemented by additional provision for their support. To meet this 
latter contingency, contracts involving both the annuity principle and the 
insurance principle have been developed. 

The reversionary annuity .—One of these combination contracts devel¬ 
oped to meet the demand for a method of protecting a dependent in the 
event of the death of the breadwinner, is the reversionary annuity which 
provides for the payment of a life annuity to a beneficiary commencing 
upon the death of a designated person known as the insured. 

For example, a son may employ the reversionary annuity to insure a 
life income to his mother, should she outlive him. The contract may be 
paid for by a single premium or by a limited number of annual premiums, 
continuing, however, only so long as the mother and son both live. Upon 
the death of the son, the annuity payments to the mother commence. 
Should the mother die before the son, the contract terminates and all 
premiums paid are forfeited. 

Where there is a considerable difference in the ages of the insured and 
beneficiary, the reversionary annuity renders its greatest service, and 
under these circumstances it is well adapted to the protection of the older 
of the two lives in the event of the death of the younger. Where the ages 
are more nearly equal, however, or where the beneficiary is younger than 
the insured, the reversionary annuity possesses many weaknesses. 

The monthly income policy .—A modified form of the same contract is 
the monthly income policy. The monthly income policy remedies in large 
measure the weakness discovered in the reversionary annuity. In the 
first place, the income payable upon the death of the insured under a 
monthly income policy is payable monthly for a fixed number of years 
certain and thereafter during the remaining lifetime of the beneficiary. By 
the phrase “fixed number of years certain” it is meant that when the 




280 risk and risk-bearing 

income becomes payable by the death of the insured, the income during 
the so-called “period certain” is guaranteed irrespective of the life of the 
beneficiary. On this account, it is possible to change, ad libitum , the 
beneficiary who shall receive the “income certain”; and as the “period 
certain” is frequently twenty years, the privilege is a valuable one. The 
income payable after the expiration of the period certain is usually payable 
only during the lifetime of the beneficiary originally designated. 

Immense improvement of the income policy upon the reversionary 
annuity is that it protects any children who may be living at the death of 
the insured. The fact that the income is payable certainly, for say twenty 
years, insures that the children will receive an income until they have 
acquired an education and have become self-supporting. 

Furthermore, the monthly income policy possesses a cash surrender 
value based upon insurance value of the income payable during the period 
certain; whereas the reversionary annuity makes no provision for cash 
surrender. 

The most complete form of monthly income policy adds to the one just 
described, a further provision under which the income commences upon the 
insured’s living a specified number of years, or say to age sixty or sixty-five. 
In this event, the income is paid to the insured during his remaining life¬ 
time, and after his death to the beneficiary, with a guaranty that payments 
for a period certain will be made if both the insured and the beneficiary die 
during the period. If the insured dies before the date when his income is 
due to commence, the income is paid to the beneficiary for life, with the 
guaranty of income for a period certain. This contract is adapted to 
furnish complete protection to a husband and wife, and also protection, 
during minority, to any children living at the death of the insured or at the 
time the income to the insured commences. 1 

Disability clauses in life insurance policies present innumerable 
differences of detail, but fall into two general types. Some provide 
simply for the cessation of premiums during the continuance of total 
disability, prior to a specified age, usually sixty or sixty-five. Such a 
provision may be very useful in enabling the insured to keep his 
policy in force at a time when he is unable to earn anything, but its 
benefits are of very small financial significance, as the average length 
of life of disabled persons below age sixty, as generally estimated, 
is less than a year and a half. 

The second type of disability clause provides for the payment of 
benefits under the policy, usually in instalments, in the event of total 
and permanent disability. A great variety of clauses of this general 
type are offered. Some simply provide for the payment of the face 

1 Adapted by permission from M. A. Linton, “Life Annuities,” Annals of the 
American Academy of Political and Social Science , LXX (March, 1917), 20-35. 




LIFE INSURANCE 


281 


of the policy, with interest, in annual or more frequent instalments 
over a period of twenty years, from beginning of total disability, with¬ 
out regard to the time of death of the insured. Others provide for 
payment of such instalments during the period of disability, and the 
payment at death of any balance remaining unpaid at that time. Still 
others provide for payment of the instalments during continuance of 
disability, and also the payment of the full amount of the insurance 
at death. The rates also vary a great deal, as there are no generally 
accepted tables indicating the extent of the risk insured against under 
these clauses. A number of companies are using their own experience, 
which has not been published. 

Disability clauses of the first type, those providing only for 
cessation of premiums, cost very little (twelve cents per thousand 
dollars per year on a thirty-year term policy at age thirty-five, accord¬ 
ing to one company’s rates), but the clauses which provide for the pay¬ 
ment of disability benefits of a substantial character are relatively 
expensive. 

Logically, every contract of life insurance should contain a clause 
providing for the payment of the face value, either in cash or in 
instalments, in the event of permanent total disability. The con¬ 
tingency insured against in a fife policy is the loss of income due to 
death. The loss incurred in the event of total disability is of the same 
character as that sustained in the event of death, and is even greater 
in amount, for the cost of support of the insured individual, which 
ceases at death, continues and may even increase at disability. In 
the present unstandardized state of the disability clause, however, the 
disability clause requires very careful scrutiny in order that the 
insured may be assured that he is getting value equivalent to the cost. 1 

War risk insurance .—One of the most interesting experiments in 
recent fife insurance history is the establishment of the War Risk 
Bureau under the federal government to furnish life insurance for 
soldiers and sailors during the Great War. The idea underlying the 
establishment of this type of insurance was that the soldier or sailor 
should be given the opportunity to secure protection for his dependents 
against the risk of death during military service, or the years following, 
on terms which would throw upon the government the cost of pro¬ 
tection against hazards due to the war, while the individual paid 

1 Leading discussions of disability clauses are Bruce D. Mudgett’s two articles, 
“Total Disability Provision in American Life Insurance Contracts,” Annals of the 
American Academy of Political and Social Science, Vol. LIX (May, 1915), and “Five 
Years’ Progress in Disability Protection,” ibid., Vol. LXX (March, 1917). 


282 


RISK AND RISK-BEARING 


the cost of insuring him against the ordinary hazards of peace. This 
was accomplished through the creation of the War Risk Bureau, which 
undertook to write life insurance on the entire military and naval 
force. The policies as originally written were five-year term policies, 
and the premiums were net premiums without loading, the entire 
expense of administration being absorbed by the government. 

As the mortality during the war was very high and was expected 
to be still higher, there was no expectation that the premiums would 
be adequate to meet the losses. The government spent a large amount 
of money in urging those eligible to take advantage of the insurance 
offered, and was successful in writing more than four million policies. 
As soon as the armistice was signed, however, the greater proportion of 
the policyholders ceased the payment of premiums. In 1919 it was 
reported that less than a million policyholders were keeping up their 
payments. In order to check the decline the Secretary of the Treasury 
issued a ruling permitting discharged soldiers, sailors, and marines 
who had dropped or canceled their policies to reinstate within eighteen 
months after discharge without medical examination and without the 
payment of back premiums, except one month’s premium to cover the 
period of grace when the policy was in force. The only limitation on 
the privilege was that the applicant should be in as good health as he 
was at the date of his discharge. In spite of this liberality the decrease 
in number of policyholders continued so that only about 550,000 
policies are now in force. 

As a very large proportion of the holders of these policies were 
young men without dependents, who in the normal course of events 
would not have been in the market for insurance for some time and 
would not have bought $10,000 policies for many years, it is not 
strange that the lapse rate has been very high. The tendency to 
discontinue payment of premiums was aggravated by dissatisfaction 
over the large number of errors made by the Bureau and the extreme 
slowness with which it worked. The necessity of converting the term 
policies into higher-priced policies also, in all probability, contributed 
to this tendency to lapse, as did the very liberal policy of reinstatement. 

The optional conversion privilege offered a choice of whole fife 
policies, twenty- or thirty-year limited payment or endowment 
policies, and endowments maturing at age sixty-two. 

Most of the liberal policy features developed by legislation or by 
the competition of life insurance companies in recent years were 
included—high loan and surrender values, option of monthly, quar- 


LIFE INSURANCE 


283 


terly, or annual premium payments, exemption of proceeds from taxa¬ 
tion and from the claims of creditors, and incontestability from date 
of issuance, the last provision one which seems to offer an unnecessary 
incentive to fraud. The disability clause is extremely liberal, pro¬ 
viding for payment of $5.75 per thousand dollars insurance monthly 
for the period of total disability, or for 240 months in case of death 
before the expiration of that period. Similar clauses in private 
insurance contracts usually cover only disability incurred before a 
specified age, sixty, sixty-five, or seventy years. In view of the very 
large proportion of aged persons who incur disability, this feature is 
of considerable importance. 

With regard to the success of the government’s experience with 
life insurance, opinions will differ for many years. In the author’s 
judgment, the fundamental principle on which the cost was divided 
between the insured and the government was thoroughly sound, and 
the object aimed at, namely, the avoidance of the pressure for pensions 
for dependents in years to come, was an eminently worthy object. 
In view, however, of the progressive liberalization of the policy and the 
pressure for other types of financial assistance to veterans of the war, 
it appears extremely doubtful whether the insurance will not prove 
to be an addition to, instead of a substitute for, our traditional pension 
legislation. 

The wisdom of handling the insurance through a government 
bureau is more debatable. At the time the experiment was under¬ 
taken no life insurance company was in a position to handle the 
volume of business created by the war emergency, and few companies 
would have cared to risk the loss of good will resultant from disrupting 
their organizations in an attempt to do so. As the number of the 
insured grows smaller, however, the necessity for handling this pro¬ 
gram through a government bureau grows less. From a purely busi¬ 
ness standpoint, it would probably be desirable to transfer the con¬ 
tracts in time to a syndicate of insurance companies if it were politically 
feasible to do so. No such action appears probable, however. 

The chief criticisms which may fairly be leveled at the insurance 
administration have to do, not with the routine clerical labor but with 
matters of policy. In the first place, the selling methods which have 
at times been, used by the Bureau have been the subject of well- 
merited criticism. For instance, in 1918, a circular issued by the Bu¬ 
reau set forth the claim that the government policy offered insurance 
at a rate 30 per cent below that offered by any commercial company, 


284 


RISK AND RISK-BEARING 


a figure which was apparently arrived at by treating a policy for 
$10,000 payable in monthly instalments over a period of twenty years 
as the equivalent of a policy for $10,000 payable in cash, without 
regard for the item of interest. 

The exclusion of term insurance from the list of policies to be 
issued after five years from the close of the war, is also hard to justify. 
Term policies are not popular, the candidate for insurance being apt 
to infer that if he lives out the term of the contract he has given 
something for nothing. The hostility of most insurance companies 
to term insurance has encouraged this attitude. The War Risk 
Bureau had an opportunity to do an excellent piece of educational 
work on this point, but has chosen instead to adopt the traditional 
viewpoint, treating the term policy as a makeshift and urging early 
conversion into the more “permanent” types of investment policy. 

As already noted, the feature of incontestability from date of 
issuance seems to be unnecessarily liberal, and to offer incentive to 
fraud. The complete exemption of the proceeds of policies from all 
claims of creditors enlarges upon a bad custom. Such exemption is 
very general, so far as life policies payable to dependents are con¬ 
cerned; the government policy offers such protection even to the 
proceeds of endowment policies. There is little justification for such 
exemption in any case, and least in the case of endowments. 

Sweeping statements by the Bureau that the government will 
never turn this business over to private companies, while they will 
probably be justified by the results, do not seem to be justified by 
the present legal situation. There is no legal difficulty in the way of 
any future Congress abolishing the Bureau, and either turning the 
insurance over to private companies or canceling the policies and pay¬ 
ing the policyholders the cash surrender value of their insurance. 
Such an action seems at the present time politically impossible, but 
in view of the startling changes of political outlook, which frequently 
take place in a few years, the positive statements to the contrary by 
the Bureau’s representatives are hardly justified. 

From the standpoint of the insured, the war risk policy is decidedly 
attractive. In the first place, it offers a standard policy at net table 
rates, the lowest rates at which non-participating insurance can be 
offered by a legal reserve company. Second, the policy, as already 
noted, contains a very liberal disability clause, for which no allowance 
is made in figuring the premium. This feature makes the policy the 
cheapest insurance of its type in the market. Third, the policy is 


LIFE INSURANCE 


285 


a participating policy, sold at non-participating rates. To be sure, 
this feature does not, on the face of things, appear to be of much 
importance, for of the three chief sources of dividends on insurance 
policies, only one appears to be available in connection with the war 
risk policy. There can be no savings from expense loading, for there is 
no loading. Mortality savings appear very remote, for the experience 
during the war was very unfavorable, and the present list of policy¬ 
holders contains a high proportion of disabled veterans, among whom 
the mortality must be excessive. There remains the possibility of 
gains from investments. The statement of assets and liabilities as 
of December 31, 1921, showed total assets in the government life 
insurance fund, amounting to $45,515,362.12, over $42,000,000 of 
which was invested in United States bonds (book value). Assuming 
earnings of 4! per cent on the entire body of assets, the gross invest¬ 
ment earnings would be less than $2,000,000, of which amount over 
$1,000,000 is required for interest accumulation on the policy reserve 
of $29,387,889, leaving less than $1,000,000 to offset excess mortality 
and provide for dividends. Yet $1,750,000 was shown in the same 
statement as reserved for dividend payments during 1922. In 
the absence of definite information as to the way in which earnings 
have been figured, it is difficult to resist the conclusion that such 
distributions as have been made were based rather on political expedi¬ 
ency than on bona fide earnings. 1 

This last point suggests a fourth advantage of a war risk policy, 
from the standpoint of the holder, namely its speculative value, which 
arises from the uncertainty which exists concerning future changes in 
the rights and obligations of the policyholder. That future legislation 
will reduce the benefits to be derived from the ownership of these 
policies seems highly improbable, while there is a considerable chance 
that changes may be made which will reduce the premium payments 

1 The dividends paid in 1922 ranged from $1.53 to $2.04 per $1,000 of insurance 
on ordinary life policies, and from $1.68 to $213 on twenty-year endowments. 
Inquiry from the War Risk Bureau concerning the source of dividend earnings has 
elicited only the information that “the fund from which dividends on converted 
policies may be apportioned is accumulated from two sources: savings due to 
deferred mortality and excess interest earnings.” On the other hand, a pamphlet 
issued by the War Risk Bureau in 1920 stated that more than $1,000,000,000 in 
claims had been allowed, and only about $300,000,000 had been collected in pre¬ 
miums. New and Liberal Features of War Risk Insurance, p. 7. It is of course 
possible that the 1922 dividends were based on 1921 mortality experience, without 
consideration of the accumulated excess mortality. 


286 


RISK AND RISK-BEARING 


or increase the benefits. Under our system of government, the odds 
in such a speculation are all in favor of the holder. He has a hand in 
the treasury, and the longer he holds his policy, and the more generally 
his fellows surrender theirs, the more valuable does his position become. 
From a purely financial point of view, therefore, it seems clear that 
any holder of a war risk policy who now has, or expects ever to have, 
need of insurance, has much to gain and little to lose by keeping his 
policy in force. 


QUESTIONS 

1. Explain the meaning of the following terms: adverse selection, benefit 
of selection, reserve, loading. 

2. What are the advantages of each of the leading types of “old line” life 
insurance policy? 

3. Why should the cost of insurance in the later years of life, under the 
natural premium plan, become prohibitive? Is insurance bought more 
cheaply by paying for it years in advance ? 

4. Calculate the value of your own life for insurance purposes, making 
reasonable assumptions concerning your prospective earnings and per¬ 
sonal expenditures. 

5. At what time of life is the maximum amount of insurance necessary in 
order to cover the amount at risk? 

6. How much insurance is it good business policy to keep in force on the 
life of a retired business man ? Does the state of his health at the time 
of his retirement have any bearing on the answer ? 

7. An unmarried woman, 35 years of age, a teacher, is the sole support of 
her mother, aged 73. She is advised to take out $4,000 of twenty-year 
term insurance, and $4,000 of twenty-payment life insurance, in order 
to combine protection for her mother with provision for her own old age. 
Could you give her better advice ? (Her salary is $1,750 per annum). 

8. A and B are brothers, sons of C, a widower. C at age 65 notifies A and B 

that he will no longer keep up premium payments on two policies in their 
favor on his life, one of which is an ordinary life policy in a legal reserve 
company, taken out at age 35, the other a beneficial certificate in a 
fraternal order, taken out at age 28. Both the insurance company and 
the fraternal order bear good reputations. C is in excellent health. A 
and B are in no way dependent on C’s income, which is chiefly derived 
from investments, though he earns enough to pay his living expenses from 
the practice of a profession. The rate on the fraternal certificate is $9.00 
per thousand, on the old-line policy $21.00. A and B decide to keep up 
the payments on both contracts. Is this decision wise (a) in the case of 
the legal reserve policy ? ( b ) in the case of the fraternal benefit certifi¬ 

cate? 


LIFE INSURANCE 


287 


In the case above cited, three years after the brothers assume responsi¬ 
bility for the premium payments, A proposes to B to sell his interest in 
the fraternal policy. C is still in good health. The following bargain 
is struck: B is made sole beneficiary. B is to pay A the present worth 
of half the face of the policy, discounted at an agreed rate of interest for 
the term of C’s life expectancy as shown by the American Experience 
Mortality Table, less the present worth of the premiums on the half 
policy which would fall due within said life expectancy. 

Is this a fair bargain ? If not, what other factors should be taken 
account of to determine a fair price for A’s interest ? 


CHAPTER XIV 
FIRE INSURANCE 

Of the various types of property insurance, fire insurance is much 
the most important from the standpoint of the amount of insurance 
written and the number of individuals protected. The usual types 
of fire insurance transaction will therefore be discussed in some detail, 
leaving other kinds of property insurance to be dealt with more briefly 
in chapter xv, chiefly by comparison of their practice with that of 
fire insurance. 

The subject-matter of this chapter will be discussed in accordance 
with the following outline: 

I. The risk insured 

II. Policy contracts 

III. Special provisions in insurance contracts 

1. The mortgage clause 

2. Coinsurance 

3. Three-quarter loss clauses; three-quarter value clauses 

4. Use and occupancy, profit, and rent insurance. 

IV. Company organization 

1. Stock companies 

2. Mutual companies 

3. Lloyds associations 

4. Reciprocal insurance 

V. Rates and rate-making 

1. Methods of rating: judgment, schedule, experience rating 

2. Rate schedules: the Universal Mercantile; the Dean 

I. THE RISK INSURED 

The risk covered by fire insurance, the hazard of loss from the 
destruction of property by accidental or incendiary fire, is one of the 
most serious risks with which business has to contend. The extremely 
destructive character of accidental fires, the frequency with which 
they occur, the irregularity in the incidence of the loss, and the con¬ 
stant change in the character of the hazard combine to make the prob¬ 
lem of elimination of fire risk one of the most difficult in the whole 
field of business. The advance of civilization has brought about a 
great improvement in the techniques of fire prevention and the fight- 


288 


FIRE INSURANCE 


289 


ing of fires, but it has also brought in innumerable new hazards. 
Each change in the methods of heating, lighting, building, in the kind 
of power used in manufacture, in the methods of transportation 
employed, in short, in almost any phase of the industrial and com¬ 
mercial life, brings new hazards. The substitution of electric lighting 
for kerosene lamps reduced the number of fires, but it resulted in a 
larger proportion of very destructive fires, because fires resulting from 
faulty wiring are more likely to remain undiscovered till they have 
gained headway. Railway transportation brought in the hazard of 
fires from sparks; automobile transportation is bringing new hazards 
from the storage of fuel. The transition of the United States from a 
rural to an urban civilization made possible a great improvement 
in fire protection and encouraged more substantial construction, but 
led to a concentration of risks. The net result was, on the one hand, 
to bring about a great increase in the proportion of trifling fires, and, 
on the other hand, to increase the hazard of conflagration. The fire 
loss fluctuates widely from year to year and from community to 
community, some of its vagaries being quite inexplicable. 

There is a striking parallel between the fire loss and the cost of 
depreciation. Both the deterioration due to weathering and the 
loss due to fire are inevitable costs of doing business. Both involve 
the ultimate destruction of the capital exposed to them and hence 
require the occasional investment of large sums for replacement pur¬ 
poses. The most important difference between them is that depre¬ 
ciation goes on at a rate sufficiently uniform to enable a fairly accurate 
calculation of the time at which the replacement will be necessary 
while fire loss is highly irregular. Hence, it is more practicable to 
make provision for depreciation through setting aside annually a 
designated sum out of earnings. If the amount of a corporation’s 
property exposed to fire is great enough and the sweep of time involved 
in the calculation extensive enough, it is possible to make provision 
for destruction by fire in the same way. The number of risks and the 
range of time involved in most men’s calculations, however, are not 
great enough to make such replacement practical, hence the payment 
of insurance by numerous firms into a common fund is necessary in 
order to equalize the burden. Like the depreciation charge, the insur¬ 
ance premium is an annual contribution out of the gross income for 
the replacement of wasting capital, and through the medium of insur¬ 
ance, or through the diversification which is occasionally possible, an 
analogous degree of regularity in its incidence is secured. 


29c 


RISK AND RISK-BEARING 


The principal elements which make up the fire hazard on any 
property are the construction, the occupancy, the protection, the 
exposure, and the moral hazards. Construction and occupancy are 
self-explanatory. The chief points of importance in connection with 
construction are the combustibility of materials and the readiness with 
which flames can spread from one part of the building to another. 
Occupancy, so far as the hazard of the building is concerned, is chiefly 
important from the standpoint of the tendency of the processes 
carried on to cause fires to originate, though the tendency of the con¬ 
tents to transmit fire readily is also an important factor. In insuring 
the contents of a building, attention must also be given to a third 
factor, the extent to which the contents are susceptible to damage 
either from fire or from smoke, water, dirt, and exposure incident to 
removal on account of fire. 

“Protection” is the term applied to the facilities available for stop¬ 
ping the progress of fires. It includes both the public fire-fighting 
service and the provision made in connection with the property itself, 
such as automatic sprinklers, fire pails, services of watchmen, etc. 

' The term “exposure” refers to the risk of damage through fire 
originating outside. Nearly 30 per cent of fires are due to exposure; 
hence careful attention must be given to such factors as distance from 
neighboring buildings, location of windows, character of processes 
carried on in adjacent buildings, and similar sources of risk. 

One phase of the exposure hazard is of so much importance as to 
deserve special discussion. This is the so-called conflagration hazard, 
the risk of a fire so serious as to outrun the fire fighting facilities of a 
city and burn itself out without effective opposition. The distribu¬ 
tion of the loss due to conflagrations constitutes one of the most diffi¬ 
cult problems in insurance policy. Conflagrations do not occur with 
sufficient frequency or regularity to make possible an accurate esti¬ 
mate of the amount of loss which may be anticipated on account of 
them. The period of time required to determine the statistical fre¬ 
quency of so infrequent a phenomenon as a two million dollar fire is 
so great that before sufficient data can be assembled conditions change 
and the earlier experience becomes valueless. Before every great 
conflagration in recent years, it has been argued that the improvements 
in fire protection and the regulation of building construction had so 
reduced the conflagration hazard of the larger cities as to make it 
negligible. During the past few years, comparative immunity has 
in fact been obtained, but it will be many years before it can safely be 


FIRE INSURANCE 


291 


said that experience has confirmed the conclusions of those who deny 
the continued significance of the conflagration hazard. 

It is almost impossible to make satisfactory provision for meeting 
this kind of fire risk. Fire insurance rates, as a whole, are based on 
regional experience, and the experience of most sections of the country 
has not included a conflagration so recently that its effect shows in 
the tables of average losses. Sections which have had conflagrations, 
on the other hand, object to having their rates based on the heavy 
loss ratio which results from averaging in the conflagration losses 
with the minor losses which occur from year to year, arguing rightly 
that the fact of a conflagration’s destroying the major part of a given 
city does not create a presumption of a heavier loss ratio in succeeding 
years for the whole state or other geographical subdivision in which 
the city happens to be located. Moreover, if rates were so adjusted 
as to take care of the full risk of loss due to conflagration hazard, and 
no conflagration occurred for many years, it would be difficult to pre¬ 
vent stockholders, buyers of insurance, and taxing bodies from drawing 
the conclusion that the large excess revenues resulting from the high 
rates were a profit available for distribution as dividends. The only 
way companies can protect themselves is to keep their risks so scat¬ 
tered that no single conflagration can wipe out their surpluses, then 
if heavy losses are incurred charge them to surplus as business losses. 
Usually, after a great conflagration, a number of companies go into 
bankruptcy, thereby throwing part of the loss on policyholders, and 
frequently rates are raised for a time to enable the surviving companies 
to recoup themselves. This is quite justifiable, so far as urban proper¬ 
ties are concerned, but the increasing of rates on rural property, not 
subject to conflagration hazard, in order to take care of the losses due 
to a great conflagration, involves a real injustice. 

The moral hazard includes both the danger of deliberate destruc¬ 
tion of property, caused either by the owner, in order to collect insur¬ 
ance, or by others out of spite, and the hazard due to carelessness. 
The moral hazard is greater in fire insurance than in most kinds of 
insurance, because of the ease with which property can be burned, and 
the difficulty with which companies are able to protect themselves 
by preventing overinsurance. Only a small proportion of insured 
properties are inspected to guard against overinsurance at the time 
policies are taken out, and even where this is done there is great diffi¬ 
culty in precluding the later appearance of overinsurance through 
depreciation of buildings, price changes, decline of prosperity of the 


292 


RISK AND RISK-BEARING 


community or of the individual concern, or changes in building or 
contents made by the owner. Hence, there is a constant temptation 
to policyholders to recoup their business losses or rid themselves of 
unsalable property by arson, and a still greater temptation to neglect 
precautions which would probably be taken if the fire hazard repre¬ 
sented a real risk to the owners. 

The importance of the moral hazard is easily exaggerated, how¬ 
ever. Its importance does not consist in the number of fires which 
are caused through moral shortcomings, but rather in the necessity 
of constant watchfulness and effort to prevent an increase in their 
number. Unless nearly all the fires due to unknown causes (usually 
about 15 per cent of the total) are due to incendiarism, the proportion 
of losses due directly to moral hazard is relatively small. 1 

What risks are insurable ? As was noted in chapter xiii, the the¬ 
ory of insurance is that the effect of the contract is to relieve the insured 
from the risk of financial loss due to the event insured against, and not 
to guarantee him a certain sum of money inthe event of certain thi ngs 
happening. In fire insurance this is known as the doctrine of indem¬ 
nity. On account of the great moral hazard in this type of insurance, 
it is especially important that the insured be not given an opportunity 
to profit by the occurrence against which insurance is sought. The 
results of this situation are, first, a strict application of the requirement 
of insurable interest on the part of the insured; second, strict pro¬ 
vision that overinsurance shall not create a claim for compensation 
in excess of the loss actually sustained, even in the event of total loss; 
third, the concept of insurance as a personal contract, designed to off¬ 
set a given individual’s personal risk, and not transferable except with 
the express permission of the insurer. 

The doctrine of insurable interest means simply that the insured 
shall have an actual financial interest in the event insured against. 
If such interest exists, it is immaterial whether the insured is the actual 
owner of the property or not. Insurable interest includes those of 
mortgagees, tenants, agents, common carriers, warehousemen, con¬ 
tractors, receivers, and many others. 2 

If insurable interest does not exist the contract creates a specula¬ 
tion on the part of the insured. As has been noted previously, such 

1 About 10 per cent of fires are attributed to incendiarism. It is frequently 
stated that industrial depressions cause an increase in the fire loss, which is appar¬ 
ently due to the decline in value of property and the increased financial pressure. 
The statistics of fire losses afford little support for this line of reasoning, however. 

2 For detailed analysis see Huebner, Property Insurance, chap. iii. 


FIRE INSURANCE 


293 


a speculation is always unfavorable to the insured and favorable to 
the insurer, unless the insured either has knowledge superior to that of 
the insurer or has the power to control the outcome. In tornado 
insurance, the insurance companies can well afford to write insurance 
in unlimited amount, if their rates are properly adjusted and their 
risks are well scattered. But in fire insurance the insured often has 
superior knowledge of certain elements of risk and nearly always has 
some opportunity to exert control over the outcome; hence, it is 
extremely important that his interest in the policy be limited to the 
amount which he actually has at risk. 

This limitation is regularly secured by the contractual stipulation 
that in the event of total loss only such amount shall be payable as 
represents the actual value at the time of the fire. In some states, 
however, this provision has been set aside by the enactment of what 
are known as valued policy laws. The effect of such a law is to require 
the insurance company, in case of a total loss, to pay the full amount of 
the policy, irrespective of the question whether the property was 
worth that much or' not. Thus it puts the burden on the insurance 
company, in cases where overinsurance is claimed, to prove actual 
fraud instead of leaving open the easier defense of disputing the value 
of the property. 

Such legislation is strongly opposed by insurance companies and 
by insurance authorities generally, on the ground that it is a deliberate 
encouragement to overinsurance and to the wilful destruction of 
property. Advocates of such legislation, on the other hand, contend 
that in the absence of a valued property law, insurance companies 
can collect premiums for excess insurance, keep the premiums in the 
cases where no loss occurs, and in cases where the property is actually 
destroyed, evade the payment of part of the face of the policy by 
raising the issue of overinsurance and refunding the excess premium. 

There is a certain amount of force in this contention, but since 
no one is under obligation to take out more insurance than he has 
reason to think he can collect in the event of total loss, the insurance 
company has the better case. Valued policy laws, undoubtedly, 
increase the moral hazard, and do not carry with them sufficient com¬ 
pensating advantages to justify their enactment. 

The third result of the concept of insurance as indemnity is to make 
it strictly a personal contract, by which is meant that the insurance 
company assumes responsibility only for the loss accruing to a desig¬ 
nated individual or firm. Hence, in the event of a sale or other change 


294 


RISK AND RISK-BEARING 


of interest on the part of the insured, the insurance never follows the 
property, and may be assigned only with the written consent of the 
insurer. Such provisions are especially necessary in types of insur¬ 
ance, like fire insurance, where the moral hazard is great, but their 
application is not limited to those particular types. 

Who needs fire insurance? All who own property subject to 
damage by fire have a risk to carry, but not all such individuals can 
wisely cover this risk by insurance. As in all types of insurance, it is 
necessary that the insured group, as a whole, shall pay into the insur¬ 
ing organization more than they withdraw in payment of losses. The 
economic value of the institution arises from the two circumstances: 
first, that a single large loss is apt to be more disastrous than an equiva¬ 
lent amount lost in a series of small items, and second, that an unex¬ 
pected loss is apt to be more serious in its effects than one which is 
known and planned for in advance. 

The advisability of a given individual’s carrying any sort of prop¬ 
erty insurance depends entirely upon the proportion'between the prob¬ 
able amount of his loss, in case luck runs against him, and the total 
resources from which the loss, if it occurs, will have to be subtracted. 
This comparison reduces itself chiefly to a question of the extent to 
which one’s resources are concentrated so as to be exposed to the hazard 
of a single disaster. It is not at all a question of the financial strength 
of the property owner, except in so far as greater financial strength 
increases the probability that one’s resources will be scattered. A 
corporation which owns $1,000,000 worth of inflammable goods, all 
under a single roof, cannot afford to leave them uninsured any more, 
nor any less, than can an individual who has only $1,000 worth of 
goods, all under the same roof. In each case, the loss which is rea¬ 
sonably probable is sufficient to wipe out the capital and interrupt 
the course of business, causing, in addition to the direct damage a loss 
of good will and destruction of earning capacity. Even though, in a 
series of years, the amount paid in by the insured in premiums exceeds 
the amount which could have been lost by a single fire, the prevention 
of these indirect losses makes the transaction worth while. On the 
other hand, a corporation or individual having $100,000 worth of 
property scattered in a hundred separate lots, in different cities, has 
little need for fire insurance, unless some of the units exposed to a single 
possible fire are disproportionately large. The distribution of risk 
secured by such holdings is less complete than that secured by a com¬ 
pany which insures thousands of separate properties, but the loss in any 


FIRE INSURANCE 


29 S 

/ 

year is not likely to equal many times the total amount of the premi¬ 
ums which would have to be paid to secure insurance. The fact that 
the loss from one fire will be small relative to the total worth of the 
business means that the company has the same sort of protection from 
indirect losses that a company with more concentrated resources would 
have to secure through insurance. Whenever the property owner 
Can put in sufficient outside capital to replace his property without 
seriously upsetting his established plans of operation elsewhere, he 
can avoid the indirect losses at the point where the fire occurs just as 
well as though he replaced his capital by the investment of money 
coming from an insurance company. Thus, railway companies have 
no need to insure their smaller station buildings, though their large 
city terminals may advantageously be insured. 

Corporations which practice self-insurance, as the practice of 
carrying one’s own risk is called, should protect themselves against 
sudden calls for capital to replace fire losses by maintaining reserves 
in the form of marketable securities or other liquid assets which can 
be drawn upon for the purpose. 

II. POLICY CONTRACTS 

One outstanding difference between the situation in fire insurance 
and that in life insurance is the relative degree of standardization which 
has been attained. The legal reserve life insurance companies all 
use the same mortality tables and approximately the same interest 
rates, and the principal types of contract which are offered by one 
company are offered by nearly all. The effect of competition, how¬ 
ever, has been to develop a large number of contracts differing from 
one another in relatively unimportant details. These details are then 
used as selling points to establish the superiority of one company’s 
offerings over those of another. There is a constant stream of new 
types of disability clauses, double indemnity for accident, variant 
methods of treating the distribution of dividends, and variant methods 
of paying the proceeds of the policy. The elements with which the 
actuary deals are so few that the really important variations in the 
contract are not numerous, but the exercise of salemen’s ingenuity 
has sufficed to create an appearance of wide diversity. 

In fire insurance, on the other hand, although the experience of 
different companies has not been pooled so as to establish any satis¬ 
factory basis for standardizing the premium charge, the effect of 
competition has been just the opposite to its effect in life insurance, 


296 


RISK AND RISK-BEARING 


namely, to bring about a very high degree of standardization, both of 
the terms of the policy contract and of the premiums charged. To 
some extent this standardization has been the result of legislation 
requiring the use of standard types of policy, but in general the causal 
influence has operated in the opposite direction. That is, it has been 
the initiative of the insurance companies which has led to the uniform¬ 
ity in legislation rather than the legislation which has brought the 
companies into line. Such diversity in contracts as exists at the pres¬ 
ent time is due more to the divergence of ideas among legislators and 
insurance commissioners in different states than it is to a difference 
in the attitude of insurers themselves. 

This difference in the effect of competition on the form of the con¬ 
tract is apparently due to a difference in the attitude of most purchasers 
of insurances toward the two types of contract. Fire insurance is 
regarded as a necessity by most property owners, and competition 
between companies consists largely of a competition between agents 
to get to the prospective customer first. In life insurance, on the 
other hand, there is very little spontaneous consumer demand, and 
insurance is sold not so much by getting to the consumer first as by 
holding on to him longest. Hence, the possession of a special feature 
which can be played up as a talking point in making the payment is 
desirable from the standpoint of the life insurance agent, whose job 
is primarily one of creating interest, while in the case of fire insurance 
a divergence of the individual policy from that usually written would 
merely create additional work for the salesmen in explaining the varia¬ 
tion to a customer who is ready to buy before he is approached. 

Whatever the explanation, the tendency toward extreme standard¬ 
ization in the fire insurance contract is very clear. The policy most 
frequently written is the New York standard policy, which has been 
adopted without material modification in most states. The principal 
provisions of this policy may be summarized as follows: 

1. As previously noted, the policy insures only against damage 
sustained by the insured or his legal representatives. 

2. The policy covers loss sustained by fire and by removal of goods 
from premises endangered by fire, but does not cover currency, deeds, 
accounts, money, notes, or securities, nor does it cover damages caused 
directly or indirectly by invasion, insurrection, riot, and similar dis¬ 
turbances. 

3. The policy is rendered void by the placing of other insurance on 
the same property without the consent of the insurer. This provision 
is not intended to discourage the distribution of insurance between 


FIRE INSURANCE 


297 


different insurers, but simply to enable the insuring companies to keep 
track of the amount of insurance outstanding. Permission to place 
other insurance is always given as a matter of course unless its effect is 
to increase the total amount beyond what the insurers consider con¬ 
servative limits. 

4. The insurance company is relieved from liability during the 
continuance of certain conditions which operate to increase the hazard, 
including alterations of the building (requiring more than fifteen days 
for completion), storage of certain inflammable compounds, operation 
of factory buildings at night, vacancy of building beyond ten days, 
and, in general, any condition known to the insured which increases 
the hazard beyond that contemplated when the amount of premium 
was agreed upon. 

5. Both parties to the contract reserve the right of cancellation 
at will. In case the contract is canceled by the insurance company 
the insured is entitled to return of the full proportion of premium not 
yet earned, but in case of cancellation by the insured he is entitled only 
to the difference between the premium he has paid and the “short 
rate” for the period during which protection has been enjoyed. 

6. In case property at the time of damage is covered by more than 
one policy, the loss is divided among the insurers in proportion to 
their total liability. In case some of the insurers are unable to meet their 
liability, which is likely to be the case in the event of conflagration, 
the other insurers are liable only for their proportion of the total, not 
simply the collectible insurance. 

7. The insurance company is entitled to an assignment of any 
rights of recovery the insured may possess against any party for loss 
or damage, to the extent that payment is made by the company. 
This is known as subrogation. 

8. Detailed provisions, which need not be summarized here, 
establish the requirements in case of loss, including notice, proof of 
loss, protection of salvaged property, appraisal, method of payment, 
etc. The company reserves the option, rarely used, of replacing the 
property instead of paying the loss, but the insured does not have the 
option of abandoning the property to the company and claiming a 
total loss. 

The indorsement which fits the standard policy to the conditions 
of a particular risk is known as the rider form. This indorsement 
includes the name of the insured, the character of his interest in 
the property, and the description of the property insured. These 
forms are standardized, to a large extent, and serve as the basis 


2gS 


RISK AND RISK-BEARING 


of a classification of policies according to the character of the coverage. 
A specific policy covers a definite item or group of items in a definite 
place. A general policy covers different kinds of property in a specific 
place, the amount of each being specified. A blanket policy covers 
different kinds of property or property in different places under one 
item, the amount of each remaining unspecified. A distribution clause 
in a blanket policy provides that in the case of two or more lots not 
subject to the same hazard the insurance shall apply to each lot in the 
proportion that its value bears to the value of the entire group of items 
covered. A floating policy follows goods in transit. An excess floater 
indemnifies the owner to the extent that specific insurance carried 
may at the time of the loss be insufficient to cover the amount of the 
loss. It may apply at one or at several locations. 

m. SPECIAL PROVISIONS IN INSURANCE CONTRACTS 

To the standard policy, standardized riders may be attached 
covering such matters as the protection of the mortgagee, protection 
against gas explosions, permission to store kerosene, gasoline, and 
other inflammable commodities upon the property in excess of the 
amount permitted by the standard policy, vacancy permits, etc., and 
special modifications may be made to take care of matters not covered 
by the standard policy. Of these special provisions some of the most 
important are the following: 

The mortgage clause .—There are several ways in which the 
interests of a mortgagee may be protected. He may himself take out 
insurance to protect his own interest; he may receive an assignment 
of the insurance from the mortgagor; or he may be protected by 
indorsement of the policy creating a claim in his behalf. The legal 
effect of these various devices has been interpreted quite differently 
in different jurisdictions, and as a result there has been developed a 
standardized mortgage clause, which is generally considered the most 
satisfactory method of protecting the interests alike of mortgagor 
and mortgagee. This clause provides, first, that the insurance shall 
be payable to the mortagee, as his interest may appear; second, that 
the rights of the mortgagor shall not be invalidated by any act of 
the mortgagee, nor by change of title, increase of hazard, failure of 
payment of premium; third, that the mortgagee must on demand pay 
any premiums which are not paid by the owner, and shall notify the 
company of any change in hazard or condition voiding the policy which 
comes to his knowledge and pay any increased premium necessitated 
by such conditions; fourth, that in case of cancellation of the policy by 


FIRE INSURANCE 


299 


the insurance company the mortgagee is entitled to ten days’ notice, 
instead of the five days’ notice required in other cases of cancellation. 
These provisions seem extraordinarily favorable to the mortgagee and 
unfavorable to the insurance company, but they are almost necessary 
if the mortgagee’s interest is to be protected, since it is impossible for 
him to control all the conditions which may operate to invalidate a 
policy, when the property is in the hands of the mortgagor. In other 
words, there is a large element of risk against which neither the insur¬ 
ance company nor the mortgagee can guard; the effect of this clause 
is to put this class of risks on the insurer so long as the mortgagor acts 
in good faith. In case the clause operates to create a claim on behalf 
of the mortgagee under a policy which would not be valid against the 
mortgagor, the insurance company is subrogated to the claim of the 
mortgagee against the mortgagor, to the extent of the amount it has 
paid. In other words, if the insurance company has to pay a debt for 
a debtor who has not complied with the conditions necessary to keep 
his policy in force, the insurance company succeeds to the mortgagee’s 
position as a creditor. On the other hand, if payments are made under 
this clause to a mortgagee under a policy which is fully valid, the debtor 
is entitled to have such payments credited as payments on the debt 
which the mortgage secures. 

Coinsurance .—Coinsurance is a device adopted to protect insur¬ 
ance companies from a kind of adverse selection which arises in com¬ 
munities where most losses are partial. Under this clause the insured 
property owner can collect for partial losses only in the proportion that 
the insurance actually carried by him bears to a certain percentage of 
the value of the property. Insurance to the amount of this required 
percentage is nominally required, but the policyholder is under no 
compulsion to buy it; if he carries a smaller amount he is himself a 
coinsurer for the balance up to the stipulated percentage. The effect 
of the clause may be illustrated by the following cases: 


Value of Property 

Coinsurance 

Clause 

Insurance 

Carried 

Loss 

Amount 

Collectible 

$10,000. 

Per Cent 

80 

$4 ,OOO 

$1,000 

$ 500 

10,000. 

80 

4,000 

7,500 

3,750 

10,000. 

80 

4,000 

8,000 

4,000 

10,000. 

80 

4,000 

9,000 

4,000 

10,000. 

80 

8,000 

1,000 

1,000 

10,000. 

80 

8,000 

9,000 

8,000 

10,000. 

IOO 

4,000 

1,000 

400 

10,000. 

IOO 

4,000 

9,000 

3,600 























3°° 


RISK AND RISK-BEARING 


In case of total loss, the coinsurance clause has no effect on the amount 
payable. 

The argument in favor of the clause is briefly as follows: In 
cities where there is good fire protection, and particularly in buildings 
where parts of the property are separated by fireproof walls, the prob¬ 
able amount of the loss from a given fire is not large in proportion 
to the value of the property. In fact, taking the experience of 
insurance companies throughout the country into consideration, the 
proportion of total losses is not above 5 per cent, and in centers where 
the insurance protection is good it runs much below that figure. In 
the absence of a coinsurance clause, the effect of this large proportion 
of partial losses is to make partial insurance nearly adequate to pro¬ 
tect the property owner, and to make additional insurance after the 
probable loss has been covered extremely expensive in proportion to 
the risk. If, for instance, an individual insures property worth $10,000 
for $3,000, he is protected fully against probably three-fourths of the 
hazards his insurance is intended to cover. Another $3,000 insurance 
is much less expensive for the company to furnish and protects him 
against a much less serious risk. The additional $4,000 necessary to 
protect his property fully, protects him against a still more remote 
hazard, in many cases against little more than the risk of conflagration. 

A more logical method of meeting this situation would be to split 
the risk, charging a different rate for successive increments of insurance 
so that a small policy would be paid for in proportion to the risk it 
imposed upon the insurer. 1 A coinsurance clause accomplishes the 
same purpose in a simple way by making it practically necessary for 
the insured to take out a sufficient amount of insurance to satisfy the 
requirements of the underwriters. 

The commonest form of coinsurance is probably the 80 per cent 
clause, although requirements run all the way from 40 to 100 per cent. 

When property covered by blanket policies is scattered in dif¬ 
ferent localities or the contents of a given building are stored in 
compartments entirely separated from one another by fireproof 
walls, the case for coinsurance is the strongest. No company could 
afford to write blanket insurance without some sort of protective 
clause on property stored in this way. Before the introduction of the 
coinsurance clause, it was the practice to require a separate specific 
insurance on each compartment, but this was awkward and it was 
frequently the case that property was shifted so frequently from one 

1 This method is used in insuring fireproof buildings, under the Universal 
Mercantile Schedule. 


FIRE INSURANCE 


30I 


compartment to another that it was impossible to adjust the premiums 
and the losses equitably. This was especially true in the case of manu¬ 
facturing enterprises where the raw materials went in process from one 
section of the plant to another. 

The coinsurance clause is compulsory in many European countries, 
but in this country it has not been made compulsory and in many states 
has been prohibited by law or discouraged through administrative 
rulings. 

Three-quarter loss and three-quarter value clauses. —The hazard 
involved in insuring rural property is quite different from that con¬ 
nected with urban risks. The chief difference arises from the fact that 
the proportion of total losses is much greater in the case of rural prop¬ 
erty. This is true because frame construction is more common in 
rural than in urban architecture, because farm buildings are more 
likely to be left unobserved long enough for a fire to gain headway, and 
most important of all because of the lack of fire protection. Thus the 
moral hazard is rendered more serious in the case of rural than with 
urban property, for it is only in the case of total losses that there is 
much danger of the company’s being called upon to pay materially 
more than the amount actually lost. 

The result of the circumstances just outlined is that instead of 
encouraging full insurance by coinsurance clauses and similar devices 
the primary interest in rural insurance is to keep the amount of insur¬ 
ance relatively low in proportion to the value insured. In regions 
where insurance experience has been unfavorable and the proportion 
of total losses is high, insurers find it desirable to include in policies a 
clause limiting liability to three-quarters the value of the property, 
or in still more drastic form, to three-quarters the amount of the loss. 

Use and occupancy , profit , and rent insurance. —As has been noted, 
the standard fire insurance policy covers only the destruction and 
damage which result directly from fire, or from efforts to extinguish 
fire or rescue property from its effects. It does not provide for the 
personal or business losses which may result from interruption of the 
use of the property. Yet these indirect losses are of considerable 
volume, occasionally indeed almost as significant as the direct loss 
of property. If, for instance, a canning factory is destroyed by fire 
at the beginning of its active operating season and the full value is 
promptly paid by the insurance company, the delay incident to 
investing the proceeds in a new building and new equipment will 
probably mean the loss of an entire year’s profits together with the 
indirect costs incident to maintaining the organization during the 


302 


RISK AND RISK-BEARING 


period of interrupted production. Likewise, the destruction of a 
merchant’s stock of goods, even though the goods are replaced within 
a reasonable time, may well mean the loss of one turnover from the 
year’s business. 

To provide for such indirect losses as these, a number of special 
types of insurance have been devised which may be attached to the 
standard policy, or may be written as separate policies. Use and 
occupancy insurance, or as it is sometimes more clearly designated, 
“ business interruption insurance,” is written on buildings, and 
provides protection ( a) against the loss of anticipated profit on goods, 
the production of which is prevented by the occurrence of a fire; 
(b) against the loss of fixed charges and expenses necessarily continued 
during such interruption; but, ( c ) not to exceed a specified proportion 
(usually of the amount of the use and occupancy insurance 
for each working day lost. Fixed charges and expenses include, for 
purposes of this type of insurance, not only ordinary salaries, rentals, 
and maintenance of property, but also such items as taxes, interest, 
insurance premiums, royalties, and advertising expense. 

Profit insurance is written on merchandise held for sale, and 
covers the loss of profit which might reasonably have been anticipated 
from the sale of the goods destroyed. A similar policy is written to 
protect commission merchants against the loss of commissions on 
goods consigned to them. 

Rent insurance is written in a variety of forms. It includes 
insurance to protect a landlord against the loss of income during the 
period when his property is untenable on account of fire; “leasehold 
insurance,” payable to a tenant to protect him against the risk of 
having to pay higher rental during an interruption of his tenure of 
property held under lease, or to protect his profits from subleasing; 
and “rental value insurance,” which protects an owner occupying 
his own building against the risk of having to pay rent elsewhere 
while his building is being repaired or rebuilt. 

Use and occupancy, rent, and profit insurance are increasing rapidly 
in popularity; a further increase in their use seems probable, as they 
become better known, for they furnish protection against a hazard 
which is quite as inescapable as is the fire hazard itself. 

IV. COMPANY ORGANIZATION 

Stock companies .—The dominant type of fire insurance organiza¬ 
tion is the ordinary stock corporation, organized for profit. It is 


FIRE INSURANCE 


303 


customary to combine the business of fire insurance with marine insur¬ 
ance, and frequently other types of property insurance are also written. 

As in life insurance, it is customary to accumulate a large surplus 
to serve as a secondary reserve against extraordinary losses, and in 
the case of old companies this surplus may come to be much larger 
than the capital stock. In the early history of a company, no great 
amount of capital is needed, and under ordinary conditions it is pos¬ 
sible to expand the surplus out of earnings as fast as the capital needs 
expand. The chief function of the surplus is to provide a reserve for 
the conflagration hazard, which is a much more serious hazard than 
the corresponding catastrophe hazard in any other form of insurance 
(except crop insurance). 

Just as is the case in life insurance, the insuring company is required 
to hold reserves against its policies, which are not the property of the 
company, but of the policyholders. In the case of an insurance com¬ 
pany, it is not considered necessary, however, to keep a separate 
account of the reserve on each policy. The reserve consists simply 
of the premium paid in advance for which no protection has yet been 
given; hence can be computed for the group of similar policies, as a 
whole, more readily than it can be done in life insurance policies, 
where the reserve arises from excess premiums paid in to secure low¬ 
ered rates many years in the future. The usual custom is to treat all 
policies issued in a given fiscal year as though they were issued at the 
beginning of that year; that is, to hold at the end of the year a reserve 
of one-half the premium against all one-year policies issued during the 
current year, three-fourths against two-year policies issued during the 
year, one-fourth against two-year policies issued during the pre¬ 
ceding year, and so on. This method works out slightly in favor of 
companies which are expanding rapidly, as more than half of each 
year’s business is likely to be done in the last half of the year, so the 
amount actually due policyholders as unearned premium is somewhat 
larger than the reserve figured on the customary basis. 

Mutual insurance companies .—The two most important groups 
of mutual fire insurance organizations are the farmers’ mutuals and the 
factory mutuals. 

The Farmers’ Mutuals constitute one of the best examples of co¬ 
operative enterprise in the distribution of risks. There are about two 
thousand of these organizations in the United States, the usual scope 
of their operations varying from a township to several counties. Their 
organization is very simple, there being, as a rule, only one or two paid 


304 


RISK AND RISK-BEARING 


officials who look after the accounting, collections, settlements, etc., 
while an executive committee which receives only a nominal compensa¬ 
tion passes on application for insurance and decides matters of policy. 
The method of operation in some cases is to collect the regular premium 
charged by the stock companies, and then make rebates to members 
on the basis of the percentage saved. In other mutuals no premiums 
are collected and assessments are made to meet claims of policyholders. 
Members often give notes for a fixed sum, which is the limit of their 
liability. 

In nearly every case, the insurance written is limited to three- 
fourths or two-thirds the value of the property insured. This cir¬ 
cumstance, together with the fact that the members are usually well 
acquainted with one another’s business, makes the moral hazard very 
low, especially in those mutuals which confine their operations to a 
unit as small as one county. Few men are as ready to try to throw 
an illegitimate loss on the shoulders of their neighbors as to impose it 
on a distant, wealthy, and impersonal stock insurance company. 

While many farm mutuals have failed, the showing of the group, 
as a whole, is creditable. In states where this type of insurance is 
highly developed, the mutuals have effected for their members’ savings 
amounting to more than half the rates charged by the stock companies. 
This saving is due in part to the lower loss ratio, due to superior 
inspection and lower moral hazard, and in part to the economy of 
operation. Just as is the case with fraternal life insurance, the sell¬ 
ing costs have been, in large part, eliminated by the co-operative efforts 
of the members. Mutuals have also, in most cases, received special 
favors from the state in the form of tax exemption. Moreover, the 
homogeneous character of the risks they insure enables them to avoid 
the expense of maintaining rating bureaus, compiling experience of loss 
on different types of property, and other expense connected with the 
making of rates. Finally, it is probable that in many cases the owner 
- of farm property has been charged a rate disproportionate to that 
charged upon certain classes of urban property. Farm mutuals, by 
isolating their own class of risks, have been enabled to secure insurance 
at rates which give them the full benefit of their immunity from con¬ 
flagration hazard, while their use of the three-quarter value clause has 
freed them from much of the disadvantage resulting from the high 
proportion of total losses which characterizes farm property insurance. 1 

1 Cf. V. N. Valgren, “Farmers’ Mutual Fire Insurance,” Year Book of the 
Department of Agriculture, 1916, pp. 424-28. 


FIRE INSURANCE 


305 


Factory mutuals .—Outside the field of rural insurance the most 
important application of the mutual principle in fire insurance is in 
the field of factory protection. The cotton-mills of New England 
have been particularly successful in reducing the cost of their fire pro¬ 
tection through mutual insurance. The plan of organization is similar 
to that of the farmers’ mutuals described above. The factory mutuals 
have not only effected great reductions in the cost of insurance through 
economies of operation, but have been of especial value on account of 
the service they have rendered in reducing the actual fire hazard. 
The leading factory mutuals co-operate to maintain an elaborate 
inspection service and set a very high standard of fire protection. It 
is said that their activities have transformed some of the worst of fire 
traps into the safest kind of buildings in America. As a rule the 
factory mutuals collect the same premium that the stock companies 
charge, then make rebates of the unused premiums. These rebates 
frequently run to 50 per cent of the premium. 

Lloyd's .—A Lloyd’s Association is a voluntary association of indi¬ 
vidual insurers who divide among themselves the risk under insurance 
contracts, the number of individual insurers and the proportion of risk 
taken by each being determined separately for each transcation. The 
Association itself does not write insurance; it simply furnishes a place 
of doing business, establishes a standard form of policy, arbitrates 
disputes, and looks after matters of mutual interest to the members. 

The policy written at Lloyd’s is very simple and has been the 
subject of much less litigation than is the case with other types of fire 
insurance policy, for the reason that it is the regular practice for no 
insurer to assume liability for an amount large enough to justify his 
disputing a claim except in cases where the claim is obviously unjusti¬ 
fied. Proposals for insurance are made to the insurers through 
brokers, and the insurers sign for such amount as each of them sees 
fit to accept at the price agreed upon. In case any insurer repents 
of his bargain, he is free to reinsure, and often does so at a much higher 
premium, thus passing on the risk or distributing it over a wider group 
of insurers. 

By far the most important of the Lloyd’s Associations is the origi¬ 
nal London Lloyd’s, which is primarily an association for insuring 
marine risks, but includes in its activities insurance against a very 
wide variety of hazards, including fire. Most of the American Lloyd’s 
have been of small importance, though there are a number of exceptions. 
The London Lloyd’s does a large volume of business in’this country. 


3°6 


RISK AND RISK-BEARING 


Lloyd’s Associations are especially important as a source of insur¬ 
ance against unusual hazards which ordinary insurance companies 
do not care to handle. The insurer at Lloyd’s, being a private indi¬ 
vidual who sets his own standards, can take chances with novel types 
of hazard to which a great stock company would find it very difficult 
to adapt itself. American insurance tradition is particularly hostile 
to the acceptance of risks of such unique character that no satisfac¬ 
tory mathematical estimate of the hazard can be made. But English 
insurers, particularly the insurers at Lloyd’s, have exactly the opposite 
tradition, and will furnish insurance against almost any contingency. 
For example, during the Great War, Lloyd’s insurance was regularly 
written against the war ending, of not ending, before a fixed date. 
Much Lloyd’s insurance is written against such contingencies as bad 
weather on holidays, causing loss to tradespeople. A Lloyd’s repre¬ 
sentative, in a western city a few years ago, worked up a thriving trade 
in insuring fur coats against fire, theft, accidental damage, and any 
unfortunate event not due to the will of the owner. One applicant is 
said to have secured a Lloyd’s policy insuring him against any loss 
incurred through future damage suits against him for violence he 
might commit in a fit of anger against one of his family connections. 

Reciprocal insurance .—Reciprocal or interinsurance against fire 
is a development of the co-operative principle, which is intermediate 
in character between an ordinary mutual and a Lloyd’s organization. 
It is like the mutual form in that its members are at the same time 
insurers and insured, and in some of its forms it differs little from the 
ordinary factory mutual; in other cases its members are practically 
Lloyd’s insurers writing policies on one another’s property. The 
following article describes the reciprocal organization so well that 
further description is unnecessary: 

A reciprocal or inter-insurance exchange is a place where business con¬ 
cerns exchange with each other contracts of indemnity against fire and light¬ 
ning (or other hazard) for certain definite amounts. A is insured by B, C, 
D,andE. B is insured by A, C, D, and E. C is insured by A, B, D, and E. 
D is insured by A, B, C, and E. E is insured by A, B, C, and D. To make 
the exchange of contracts each applicant for insurance, called a subscriber, 
gives a power of attorney to a manager, called the attorney-in-fact, who 
conducts the exchange.. Suppose ioi concerns are to make the exchange, 
each having authorized the attorney to bind it for a sum not to exceed $i,ooo 
on each risk. If Concern No. i wishes $110,000 of insurance, it cannot be 
had, for there are only 100 other subscribers. It can get a $100,000 policy. 
The standard fire policy of the state in which the applicant resides is written 


FIRE INSURANCE 


3°7 


up. At the end of the policy a clause is added specifying the liability of 
each signer to be one one-hundredth part of the face, or $1,000, and the signa¬ 
ture of each of the hundred other concerns is affixed by the attorney-in-fact. 
If Concern No. 2 desires a policy for $25,000, it is signed by each of the other 
concerns under a final paragraph stating that the liability of each is $250. 
If there are 412 subscribers and each limits his liability on a single risk to 
$2,000, the largest policy that can be written is 411 times $2,000, or $822,- 
000; on a policy for $25,000 the liability of each subscriber would be $25,000 
divided by 411, which is $60.83. The amount of liability, $100, $250, $500, 
$750, $1,000, $2,000, $2,500, or $10,000, which a subscriber will assume on a 
single risk is specified in his power of attorney. 

Subscriber's agreement and power of attorney .—It would be inconvenient 
for each subscriber to receive and pass on every application for insurance. 
Therefore each subscriber delegates the power to examine applications and 
sign policies to the same person, the attorney-in-fact, who is the manager of 
the exchange. The attorney is thus enabled to do business for all in one 
place at one time. The instrument which each subscriber gives him is 
called the “subscriber’s agreement and power of attorney.” The agreement 
and the power may be separate, but usually they are together in one docu¬ 
ment. This instrument specifies all the details of the method and prescribes 
the duties that may be performed for the subscriber by the attorney-in-fact. 

Premiums and expenses .—The premium which is paid in advance to the 
manager is nearly always the same as is charged by the stock fire insurance 
companies. The manager’s compensation is a commission on the premiums. 
This commission varies according to the character of the business of each 
exchange. Many exchanges have it fixed at 25 per cent; a wholesale grocers’ 
exchange operates at 20 per cent; department store exchanges get off at 
15 per cent or even 10 per cent. What this compensation covers in addition 
to the services of the manager is illustrated by this quotation from a sub¬ 
scriber’s agreement: 

“It is expressly agreed and understood that they (the managers) shall, 
out of said compensation, themselves defray all disbursements of every 
character, except losses, counsel fees, costs and expenses of lawsuits, taxes, 
legal assessments, expenses of fire control, fees of the advisory committee, 
and all expenses incident to the investment and custody of funds and securi¬ 
ties, and of the adjustment of losses.” 

The manager himself pays for rent, salaries, traveling expenses, printing, 
supplies, etc. All premiums after expenses and losses have been deducted, 
belong to the subscribers. The most successful group of inter-insurers have 
regularly saved for themselves 85 per cent of their premiums. Another group 
has returned amounts equal to 78 per cent of the premiums received. Some 
exchanges report savings of 50 per cent, some 25 per cent, while others have 
failed absolutely and produced net losses to their members. 


3°8 


RISK AND RISK-BEARING 


Separate accounts for each subscriber. —Since the premiums are the prop¬ 
erty of the separate subscribers (every contract examined declares there 
are no joint funds), separate accounts with each member are necessary. Two 
different methods of accounting are used. Plan One. The premium of 
each subscriber is held in trust for him. Each account is credited with the 
premium received and with the earnings from the investment of the premium 
and the accumulated surplus. Each account is debited with its share of 
expenses and losses. The balance, if there is a credit balance, is the saving 
of the subscriber from the premium paid. Plan Two. The premium paid 
by a subscriber belongs pro rata to the other subscribers who have signed his 
policy. Each account is credited with its share of every premium received 
and with the earnings from the investment of the credit balances. Each 
account is debited with its proper share of expenses and losses. The credit 
balance, if there is one, is profit realized from the business of insuring fellow- 
subscribers. By this method a subscriber who carries much less insurance 
than his fellow-members may receive profits greater than his premiums. 

Reserve against unusual losses. —It is a common rule to require that all 
savings or profits be allowed to accumulate until a surplus equal to double 
the subscriber’s risk on a single policy is provided. 

Payment of excess losses. —If current losses are so great as to exceed the 
amount of current premiums and accumulated profits,what is the liability 
of each subscriber? Some reciprocals place no limit upon their right to 
assess subscribers. Some provide that each insured shall not pay more 
than his annual premium on any one risk; some that he shall not pay more 
than one additional premium on any one risk. Such provisions still leave 
no limit to the liability for aggregate losses. There is a type of agreement 
in use, however, that attempts to restrict aggregate losses to the annual pre¬ 
mium or deposit, by means of payments for reinsurance. The exchanges 
writing the largest hazards provide that in case of one fire involving several 
risks the insurance in force must be reduced to make the pro rata liability 
of each subscriber no more than a multiple of, say, four or five times the 
liability on each risk. The aggregate liability in the case of many single 
fires is still, as it should be, unlimited. Usually the subscriber authorizes 
the attorney, in the event that the surplus is insufficient to pay losses, to 
draw on him, and, if necessary, sue him for the amount, provided the maxi¬ 
mum liability of the subscriber has not been reached. Sometimes the agree¬ 
ment calls for a flat sum to be paid on demand in case of excess losses. It 
is always possible to authorize the attorney to insure the subscriber against 
excess liability. Some of the exchanges provide regularly for the deduction 
of 5 per cent of the premiums to take care of this cost of reinsurance. Maxi¬ 
mum liability is the knottiest problem of the reciprocals. Can you limit 
liability and still have good insurance ? The proper solution is not to weaken 
insurance by attempting to restrict liability by contract, but to lessen losses 
by sound underwriting, and not assume the hazard of conflagration. Here 


FIRE INSURANCE 


309 


is one such plan: “It is our policy not to write more than the equivalent 
of one risk limit in any one city block or square, and not to write more than 
the equivalent of five risk limits in any city.” When maximum limits are 
involved the subscriber must know how many risks are about him. If his 
contract limits his liability on a single risk to $1,000 and to four times that 
on a single fire, and there are eight other risks in that area besides himself, 
he is only one-half insured against conflagration. If there are only four 
other risks in that area, he is insured to the face of his policy even if a con¬ 
flagration occurs. 

Special class insurance .—The big advantage claimed for reciprocal 
insurance is that it is more economical. How is it possible to insure for less 
than is charged by the stock companies, the best of which lead the world 
in insurance ability ? The factory mutuals of New England proved that if 
only the highest class risks of one kind were studied and accepted the cost 
could be reduced. This idea is characteristic of the best reciprocals. 

An examination of the risks of reciprocals shows them to be certain 
special lines such as bank buildings, steam laundries, steam bakeries, lum¬ 
ber mills, wholesale houses, drug stores, hotels, and department stores. 
An inter-insurer of hotels and drug stores says: “We write only upon build¬ 
ings of brick, stone or fireproof construction and the contents therein, in 
towns or cities with adequate fire protection.” One exchange advertises 
the following safeguards: “Elimination of moral hazard; wide separation 
of risks; rigid inspections; thorough equipment of automatic sprinklers— 
no exceptions.” The manager of another exchange says: “The principal 
features that make for the success of our insurance are the following: No 
concern worth less than $125,000 is eligible on account of the assessment 
feature; in other words, he must be strong enough financially to meet an 
assessment of $20,000 without flinching, if called upon to do so (no assess¬ 
ments have been made for twenty years). No application is approved 
unless the concern is of the highest commercial standing in the community. 
Our inspection department is a most important adjunct and we maintain a 
corps of specially trained men at a very heavy expense, who do nothing but 
inspect our risks from the Atlantic to the Pacific four times a year. Our 
subscribers, who are not in business to burn, cheerfully cooperate with our 
efforts to minimize the fire hazard.” 

The writer went to a subscriber to this reciprocal and asked him if he 
would show him the signatures to his insurance policy. As he read over the 
names of America’s leading merchants, he realized the literal truth of what 
the attorneys had written him and began to comprehend how it has been pos¬ 
sible for this group during twenty-five years to have a loss record of only 
$536,000 and to pay back to its members a total of $6,000,000 in cash refunds. 

The advisory committee, or trustees .—The advisory committee is a part 
of every reciprocal organization. In some cases it is a real power, though 
in others the opponents of the method declare the members of the committee 


3 io 


RISK AND RISK-BEARING 


to be figureheads utilized by profiteering managers. This committee is 
elected by the subscribers and has three, five, or seven members. 

Objections to reciprocal insurance .—The chief objections to reciprocal 
insurance have been summarized by John F. Ankerbauer 1 who has been one 
of the leaders of those opposing the method. They are as follows: 

1. Subscribers do not understand the nature of their obligations under the 
subscriber’s agreement; they have little or no knowledge of the obligations 
incurred for them by their attorney-in-fact. This objection can be met by the 
subscriber’s studying carefully his power of attorney, his articles of agree¬ 
ment, and the reports of his attorney which every agreement should require 
at frequent intervals. Such study should lead to care in the choice of a 
reciprocal. 

2. Reserves are inadequate. This has been true of some reciprocals. It 
is true of every exchange that fails. A prospective subscriber should shun 
a reciprocal unless adequate reserves as required of old-line companies are 
maintained. He should make sure that there is both a premium reserve and 
an accumulated surplus as a provision against unusual losses. He should 
also find out whether a sound policy for investing reserves such as is com¬ 
pulsory for stock companies is carefully followed. 

3. The subscriber does not know the identity of his fellow-subscribers who 
are insuring him. Unfortunately some exchanges are doing business in 
such a fashion. They should be forced to change their method by lack of 
business. Nobody should think of taking insurance from unknowns. 

4. Some exchanges mix the business of separate industries when the insur¬ 
ance by groups is supposed to be distinct. If steam laundries, bakeries, and 
hotels insure each other at the same exchange, each insuring others of the 
same industry only, it is a misrepresentation when the accounts of resources 
and liabilities are not kept entirely separate and so reported. 

5. If the attorney does not settle a loss satisfactorily , suit has to be brought 
against too many persons in too many places. Most contracts provide that 
the attorney shall accept process, permitting all suits to be brought in one 
place. The prospect of legal trouble emphasizes the importance of dealing 
only with a high-class exchange composed of manager and subscribers of 
unquestioned responsibility and integrity. Legislation for reciprocal insur¬ 
ance, as pointed out below, attempts to simplify the matter of bringing suits. 

6. It is beyond the power of a corporation to have such insurance unless 
its charter gives it permission to engage in the insurance business; if such par¬ 
ticipation is not legal , no liability can accrue. There have been some court 
decisions supporting this view. In one state some large concerns have 
withdrawn from reciprocal exchanges on account of the advice of counsel 
that the above objection is well taken. 

1 Inter-insurance Information, 32 pages. (Cincinnati: John F. Ankerbauer. 
Not dated.) 


FIRE INSURANCE 


3ii 

Since authorities differ it becomes necessary in each state to discover 
the weight of opinion and act accordingly. The uniform reciprocal law 
which has been adopted in so many states clears up this problem by provid¬ 
ing expressly: “Any corporation now or hereafter organized shall, in addi¬ 
tion to the rights, powers and franchises specified in its articles of incorpora¬ 
tion, have full authority and power as a subscriber to exchange insurance 
contracts of the kind and character herein mentioned. The right to 
exchange such contracts is hereby declared to be incidental to the purposes 
for which such corporations are organized, and as fully granted as the rights 
and powers expressly conferred upon the corporation.” 1 It is said that the 
constitutionality of such a blanket addition to charters of all corporations 
will be attacked. 

7. Just as serious, in some states, as objection number 6 has been the 
view of some state insurance departments that inter-insurance without a 
license from the state department is contrary to law. 

Before the passage of the reciprocal insurance law by Virginia in 1918 
agents in that state were subject to arrest. Persons who wished such insur¬ 
ance went to New York, Chicago, St. Louis, or Kansas City, Missouri, for 
it, and became parties to agreements with firms and corporations not resi¬ 
dent in Virginia. This practice was so general in states not providing by 
law for reciprocal insurance, that a manager of a western exchange said that 
he expected to write little more insurance in a certain state after the law was 
passed than he had been writing before its passage. 

8. A reciprocal insurance agreement forms a partnership; liability cannot 
be restricted by contract , and each subscriber may be liable for the entire face of 
the policy. This objection seems doomed, certainly in states where such 
insurance is provided for by statute, and in any other state where such a 
contract is not repugnant to its constitution or statutes. There seems no 
doubt of the limited liability if the attorney signs each policy separately for 
each subscriber, and specifies that the liability is several and not joint. If 
every subscriber has made the same kind of usual agreement, there is no 
partnership. Every subscriber possesses that agreement in duplicate, or 
has seen it, so there are no innocent third parties. 

9. The attorney-in-fact has too much intrusted to him; he is an autocrat. 
There is great danger here. To safeguard against an incompetent or a dis¬ 
honest manager, a strong advisory committee or board of trustees must be 
provided. Unsafe underwriting and insufficient inspection are to be guarded 
against. In practically every case the manager’s compensation comes from 
a percentage of premiums. He is tempted to assume risks that are less 
good and to give the applicant the benefit of the doubt. He is less likely 
to yield if he realizes that, as losses increase, subscribers diminish; but the 

1 Section 9, Ohio House Bill No. 325, 82 General Assembly, Regular Session, 
1917. 


312 


RISK AND RISK-BEARING 


best restraining influence is to subject him to the control of the subscribers 
acting through a committee. 

io. The advisory committee does nothing; it trusts the attorney. Unless 
the committee is annually elected by the subscribers, given authority over 
the managers, and paid for their services, this is a real objection. While a 
competent manager must have a free hand, certain exchanges have trustees 
who really act as a board of directors. Within the past year the manager 
of one exchange was retired. 

Advantages of inter-insurance. —The advantages that are claimed for 
reciprocal insurance are as follows: 

1. The expenses of operation are less, due to dealing with a particular 
class of risks, permitting specialized service, and the reduction of local commis¬ 
sions to a minimum. Many exchanges have no local commissions to pay. 
Some exchanges operate at a low cost, but there are others that have saved 
little or nothing for their subscribers. 

2. All hut high-class risks are eliminated. This is true for some exchanges 
and untrue for others. 

3. Frequent inspections by trained inspectors. This is a great advantage 
of some of the exchanges. There are others that do very little along this 
line. 

4. Consolidation of small policies into a large one. Many companies 
will not write more than a small part of the insurance of a large concern. 
The insurance obtainable by the reciprocal method in one policy runs all the 
way from a small amount up to over one million dollars. 

5. The probable large saving. Some people have not saved anything; 
others save 25 per cent to 85 per cent of their premiums. 

Legislation. —The sweep of legislation to favor reciprocal insurance and 
to control it indicates that the states recognize both the strength of the 
reciprocal method and the dangers of its misuse. The main features of such 
legislation are: (1) to require reciprocals to file copies of their agreement, 
powers of attorney, and contracts; (2) to make complete reports of their 
condition to the department of insurance; (3) to compel the maintenance 
of premium reserves, a minimum amount of business, and the possession 
at all times of such an amount of quick assets as to make certain their ability 
to settle at once a heavy loss; (4) to enable a suit to be brought by a claim¬ 
ant in his own county against the attorney, or any, or all of the subscribers 
by serving process upon the state insurance commissioner who is declared 
to be the representative for that purpose of the attorney and each of his sub¬ 
scribers; and (6) to tax the business of reciprocals as other insurance is taxed. 

Conclusions. —A study of the methods, advantages and disadvantages 
of reciprocal fire insurance leads one to conclude that the principle is sound, 
but that such insurance is neither incompetence-proof nor crook-proof. 
In theory the attorney-manager is the agent of his principal, the subscriber. 


FIRE INSURANCE 


313 


That is proving to be the soundest practice. The attorney ought to be 
subject to control by the subscribers. Just as directors are a real force in 
the management of a bank or insurance company, so the advisory committee 
ought to be in a position, if need be, to assert its authority over the attorney. 
It seems contrary to good principle for an agreement to read as one did: 
“Neither the subscriber or subscribers, has, have, or shall have, any owner¬ 
ship or property interest in or to the business, plan of business, system of 
indemnity insurance, office or office property of the attorney-in-fact, or any 
property right in or to said exchange.” The manager must be a successful 
underwriter and a man above reproach, committed to the welfare of his 
principals, rather than a self-seeking adventurer. All but high-class risks 
must be eliminated, and rigid, frequent inspection must be enforced. For 
people who intend to adopt every means of preventing fire, who themselves 
constitute no moral hazard, whose commercial integrity is the highest, whose 
several properties are widely scattered, but whose interests draw them so 
closely together that they have knowledge of each other’s integrity, there is 
a profitable field for reciprocal insurance. For other people the range of 
liability is so great that the value of the plan is doubtful.' The business 
man must proceed as carefully in its use as if he were buying stock in a corpora¬ 
tion or extending a line of credit. Instead of getting insurance he may increase 
his liabilities. Rockefeller’s success in oil does not foreordain the success 
of every oil project. 1 

V. RATES AND RATE-MAKING 

The rate in fire insurance is quoted as the number of cents per 
annum per hundred dollars insurance. Considerably lower rates 
are granted on three- or five-year contracts, in some cases five years’ 
insurance being sold for as little as three times the annual premium, 
while on the other hand the “short rate” for less than one year’s 
insurance is much higher than the annual rate. The practice of 
extending much lower rates for long than for short contracts is due 
to several causes. The burning rate is somewhat higher during 
the earlier period of the life of the average policy, presumably on 
account of greater moral hazard; the selling costs are less on long¬ 
term than on short-term policies, and the office expenses connected 
with the issuance of the policy are of course proportionately much 
greater on short contracts; the excess premium on a long contract 
is a clear gain in case a total loss occurs in the earlier period; and 
the danger of losing a given piece of business to a competitor grows 
less as the term of the contract increases. 

1 Adapted by permission from J. Anderson Fitzgerald, “Reciprocal or Inter- 
Insurance against Loss by Fire,” American Economic Review , X (March, 1920), 
92-103. 


314 


RISK AND RISK-BEARING 


The determination of the proper level of insurance rates, as a 
whole, is not an extremely difficult problem, but the proper apportion¬ 
ment of the burden is a source of great perplexity and controversy. 
The problem is not dissimilar to that which arises in connection with 
freight rates, where the determination of the amount necessary to 
maintain service and provide a fair return on capital is simple com¬ 
pared to the problem of distributing this cost to the various kinds of 
service rendered. In fire insurance, the difficulty arises from the 
irregularity of the incidence of fire loss from year to year, and from 
the extreme complexity of the factors which make one individual risk 
greater than another. The total income of the insurance company, 
if the business is to continue, must be great enough to provide for 
normal losses, the expenses of carrying on the business, a contribution 
to a conflagration reserve, the proper size of which is a matter of 
conjecture, and a fair return on the invested capital. As the bulk 
of the invested capital is in the form of income-bearing securities, 
however, the necessary return to capital from the insurance operations 
is quite small. Aside from the small fixed assets and the money used 
up in organization expenses, the capital pays its own way, except for 
the return necessary to compensate investors for exposing their 
capital to the hazard of loss through conflagration. In many years 
the underwriting profit is quite small, but over a period of years the 
business has proved very profitable for the majority of those engaged 
in it. When returns are stated as a percentage on capital, the busi¬ 
ness appears more profitable than it really is, because of the large 
amount of invested capital which is carried as surplus. Much of 
this is the result of the accumulation of past profits, but quite com¬ 
monly part of the surplus represents capital obtained by selling stock 
at a premium, a practice necessitated by the laws of certain states 
which require the entire capital stock to be held in securities of a 
specified character. 

The adjustment of the rate to the individual hazard is much 
more difficult in fire than in life insurance, because so much greater 
effort is made to take account of factors which cause variation in the 
degree of risk. Whereas in life insurance it is practicable to draw a 
line between the insurable and the uninsurable, and then subdivide 
the insurable into groups according to age alone, in fire insurance the 
rate on certain types of property is adjusted to take account of several 
hundred different elements of variation in the risk. The resulting 
groups of risks which are alike in all respects are too small to permit 


FIRE INSURANCE 


315 


statistical justification of any rate for each group separately. The 
variations in rates on different kinds of property are expressions of 
the judgment of experienced underwriters as to the effect which a 
given difference in construction, occupancy, exposure, or protection 
ought logically to exert upon the loss ratio. Each company is con¬ 
stantly studying its experience to secure a better basis for rate¬ 
making, but little has been done toward making their accumulated 
experience common property, and until much more detail has been 
made public, concerning the actual experience with different types 
of risk, fire insurance rates will remain under the suspicion of arbi¬ 
trariness. 

In most parts of the United States, rates are made by associations 
of insurers, which serve the double purpose of effecting an economy in 
the work of inspecting properties, constructing fire maps, computing 
rates, etc., and of eliminating any tendency toward cut-throat com¬ 
petition. The rates made by these associations are subject to a 
limited amount of supervision by the insurance authorities of the 
various states, some states requiring merely the filing of rates, others 
intrusting to their commissioners extensive powers of revision. In a 
few states, the full power of making rates is lodged by law in the state 
authorities. 

In adjusting the rates on individual risks, two methods are in use. 
In the case of farm buildings, dwellings, churches, and a number of 
other classes of building, where the difference in individual hazard 
is not great, the principle of classification is employed. Under this 
plan, risks are thrown together into a few classes which are roughly 
alike, and one rate is applied to the entire class, subject to a modifica¬ 
tion in the case of city property based on a rating given to the city. 
For instance, all three-story brick apartments in a given city may be 
given one rating; all frame dwellings another rating; all brick churches 
another; and so on. The second method, which is generally applied 
to mercantile and industrial property, is known as schedule rating. 
Under this system, no attempt is made to group together all risks 
entitled to the same rate. Instead, the rate is built up by establishing 
an arbitrary starting-point in a given combination of features of 
hazard, then drawing up a detailed schedule of additions and deduc¬ 
tions from a basis rate which is assumed to be applicable to this 
standard. Manufacturing risks are rated under a great variety of 
special schedules, while mercantile properties are generally rated 
under some modification of one of two systems, the Universal Mer- 


316 


RISK AND RISK-BEARING 


cantile Schedule, which is widely used in the East, and the Dean 
Schedule, which is universal in the West. 

The Universal Mercantile Schedule starts by defining a standard 
building and a standard city, and fixes a basis rate of twenty-five 
cents for the combination of these two standards. Next, the rate 
for the individual city is determined by adding specific amounts to 
the twenty-five-cent rate for specific deficiencies, such as narrow 
streets, inadequate police service,.extensive lumber districts, etc., and 
making deductions for unusually favorable features. Then by a 
similar schedule of additions and deductions, the rate for the standard 
building in the given city is converted into the rate for the given 
building. Successive modifications are then made for the character 
of the occupancy, the individual fire protection, the exposure, and 
the presence or absence of coinsurance. The rate on the contents 
is built up in a similarly complicated manner from the rate on the 
building, additions and deductions taking care of both the special 
features of hazard connected with the building and those arising from 
the character of the contents themselves. The following account of 
the rating of a manufacturing building gives a good idea of the way 
in which schedule rates are constructed: 

This particular building has been inspected and surveyed by the rater. 
The degree of municipal and local protection has been measured. This 
establishes the basis rate of .40 which is a charge commensurate with the 
degree of protection and covers all general hazards that cannot be segre¬ 
gated and measured. In passing, let it be noted that the better the city 
protection the lower will be the basis rate. 

The rate is established as follows: 

Basis rate. 

Area 15,800 sq. ft. 

(The standard unit area is 1,000 sq. ft., a proportionate 
additional charge being made for larger areas.) 

Parapet deficiency. 

Skylights not standard. 

Metal stacks through roof. 

Outside wood porches, cornices and wooden conveyor. . 

Gallery decks. 

Occupancy. 

Shavings allowed to accumulate. 

No waste cans. 

Floor oil soaked. 

No drip pans under machines. 


Total. 1.77 

Credit for open finish.08 


Building rate unexposed 


.40 

.04 




.04 

.02 

.06 

.06 

•03 

.92 

•05 

.05 

•05 

•05 


1.69 


















FIRE INSURANCE 


317 


Exposure 

From buildings No. 2 and No. 5 at 18 ft.34 

From building No. 6 at 15 ft.02 

From office at 23 ft.05 

From buildings No. 9 and No. 10.07 

Exposure charge. 

Total building rate. 


. 48 
2.17 


The occupancy charge of 92 cents in the foregoing table is made up as 


follows: 

Grinding, machine shop, and blacksmith shop.06 

Gas tempering furnace.or 

1 brick forge and 1 movable forge.01 

3 crude oil furnaces.02 

High pressure steam boiler using shavings partly as fuel 
and coal with an unapproved arrangement for shavings 

in brick room.26 

Inadequate ventilation.04 

Gasoline automobile in building.12 

Woodworking (1 pony planer, 1 rip saw, 1 cross cut)... .10 

Wire room (2 auto, wire knotters, 4 wire cutters and 

straighteners—'all on wood using oil).24 

10 hand knotting machines, additional labor, 28 hands. .06 


Total occupancy charge 


.92 


With this detailed information in the hands of the business man he 
can figure exactly how to reduce his fire insurance rate and what the cost 
of the changes will be. 

Assuming that he carries a line of $65,000 on this building his annual 
premium is $1,410.50. For each .01 reduction in the rate he is saving 
$6.50 every year. 

He finds that he can bring the parapet wall up to the standard require¬ 
ment for $30.00. By this expenditure he lessens the hazard and reduces 
the rate .04, thus saving in premiums $26.00 each year. He has the shavings 
removed daily, installs waste cans, and drip pans under the machines at a 
small expense. These improvements reduce the rate .15. He finds that 
his automobile being stored in the building is costing him $78.00 a year in 
increased premium. He puts the car in a small garage and reduces the 
rate .12. 

By comparing what the hazards are costing him with the expense of 
correcting them he determines how much he deems it advisable to reduce 
his own rate. As a matter of fact, the owner makes his own rate—the rater 
simply measures the hazards in terms of rates. 

The rate of $2.17 was reduced to $1.86 by a comparatively small out¬ 
lay of money. In addition the liability to fire has been reduced. This 
should be a stronger incentive than the saving of insurance premiums. 1 

1 Taken by permission from John J. Thomas, What the Business Man Should 
Know About Fire Insurance , pp. 12-13. (Chicago, 1922.) 



















3i8 


RISK AND RISK-BEARING 


The Dean Schedule presents several points of contrast to the 
Universal Mercantile Schedule. The starting-point under this 
system is a one-story brick building of ordinary construction, in a 
town of the sixth, the lowest, class. No rate is prescribed for this 
standard risk, the system being so constructed as to be applicable to 
any base rate which the rating bureau may consider applicable to 
the community. The additions and deductions, which adapt the 
rate to the special features of the individual hazard, are made in the 
form of percentages instead of flat charges. The theory under¬ 
lying this system is that a given defect of construction or protection 
is more serious in a building which is otherwise a poor risk than 
in the case of a building otherwise relatively safe. The system also 
provides a much more careful analysis of occupancy and exposure 
hazards than is attempted in the Universal Schedule. 

Upon the whole, the schedule rates seem to be more equitable 
than the classified rates, perhaps, however, because our knowledge 
of the actual fire losses with different combinations of the elements 
of risk is not sufficient to expose the shortcomings of the schedules. 
As is to be expected in a task of such complexity, it is impossible to 
secure a schedule which commends itself in all details to the judg¬ 
ment of any one critic, and persons disposed to do so have no difficulty 
in finding rather obvious flaws in the rating system. Until statistics 
are available, however, for determining the loss experience on a large 
number of classes of risk, we shall be obliged to content ourselves with 
the sort of imperfection which the current schedules exhibit. The 
most serious criticism is not the occasional absurdity in the relative 
rates for given risks, but the tendency for certain rates to be warped 
by the conditions surrounding the selling of insurance, conditions 
which, as a rule, work to the disadvantage of owners of property 
which falls within the classified groups. Manufacturers and mer¬ 
chants scrutinize their insurance bills carefully and chambers of 
commerce and manufacturers’ associations are effective means of 
protest against rates deemed too high. Purchasers of insurance on 
dwellings, school buildings, and churches, on the other hand, are less 
effectively organized and are apt to regard their insurance as an item 
of expense too small to be worth quibbling over, which indeed it 
often is. So conspicuous has the resulting shift of the burden from 
certain types of property become, that insurance companies have 
created an informal classification of properties into preferred and 
ordinary risks, the term “preferred risk” denoting, not a property 


FIRE INSURANCE 


319 


where the burning rate is low, but a property where the insurance 
rate is high. 

If rates were adjusted accurately in accordance with the consensus 
of insurance opinion as to the hazards involved, even though that 
opinion might involve a large degree of approximation, there would 
be no such thing as a preferred risk; one risk would offer as much 
prospect of profit as another. The notorious preference of insurers 
for certain classes of business is sufficient evidence of the inadequacy 
of present methods of apportioning the burden of insurance. 


CHAPTER XV 


MISCELLANEOUS PROPERTY INSURANCE 

Aside from contracts of life and fire insurance, there are innumer¬ 
able similar arrangements by which the risks of business are eliminated 
or reduced, through transfer to specialists and consequent combination 
of risks or prevention of the event insured against. In general, almost 
any risk is insurable, and will be insured by casualty companies if the 
following conditions are present: ( a ) a body of experience sufficient 
to afford a basis of judgment concerning the probable loss ratio; ( b ) 
a loss ratio low enough so that rates need not be prohibitively high; 

( c ) a probability of individual losses large enough to make it worth 
while for individuals to take the precaution of insuring against them; 

(d) a loss ratio high enough so that individuals are alive to the hazard 
and can be induced without excessive selling cost to provide against 
it; ( e ) independence of the separate risks, so that the company can 
secure a fair distribution of the hazard; (/) freedom of the event insured 
against from complete control by the insured. 

Of these many types of insurance, few present special features of 
interest sufficient to warrant detailed study in a general survey of 
methods of dealing with risk. The risks of labor and the insurance 
devices for taking care of financial risks associated with the labor con¬ 
tract will be considered in chapter xvii; other types of insurance 
include the following: 

Marine insurance comprises the whole field of insurance against 
risks arising from the transportation of goods, and falls into two main 
branches: ocean marine, which is what is ordinarily referred to as 
marine insurance, and inland marine, which includes such forms of 
protection as transportation, tourist baggage, parcel post, registered 
mail, and motor truck contents insurance. 

Ocean marine insurance is the oldest form of indemnity of which 
there is any record, and the policy usually written retains evidence of 
its age in the quaintness of its wording. The perils insured against 
are: 

Of the seas, men-of-war, fire, enemies, pirates, rovers, thieves, jettisons, 
letters of mart and countermart, surprisals, takings at sea, arrests, restraints, 
and detainments of all kings, princes and people, of what nation, condition, 


320 


MISCELLANEOUS PROPERTY INSURANCE 


321 


or quality soever, barratry of the master and mariners, and of all other perils, 
losses, and misfortunes that have or shall come to the hurt, detriment or 
damage of the said goods and merchandises and ship, etc., or any part 
thereof. 

Omitting reference to the items which enumerate hazards of war, 
the clauses enumerating the hazards may be explained as follows: 
“ Perils of the seas,” refers to damage from storm, collision, ice, strand¬ 
ing, and such excessive action of the wind and waves as is not antici¬ 
pated in the ordinary course of navigation. The line between ordi¬ 
nary wear and tear and damage by storm is sometimes hard to draw, 
but the principle involved is that the policy shall insure against losses 
which may happen, not those which must happen. “Pirates, robbers, 
and assailing thieves,” include all outside sources of loss through theft, 
and “barratry” covers various unlawful acts of master and crew 
(including mutiny, diversion of the ship from its course, scuttling, and 
open robbery by the crew), but neither clause covers pilferage by the 
ship’s company. “Jettison” means the throwing overboard of part 
of the vessel’s cargo for the purpose of relieving the ship in distress. 

The interpretation of an ocean marine policy is extremely technical, 
as is indeed the whole of admiralty law, and into the intricacies of the 
policy it is unnecessary for us to go. A few outstanding peculiarities 
of this type of insurance, however, may be mentioned. In contrast 
to fire insurance, the ocean marine policy is, in a great majority of 
cases, a valued policy . 1 Another contrast with fire insurance is the 
fact that under certain conditions a marine policy may be valid, even 
though at the time it was taken out the insured had no insurable 
interest in the property. This is the case where the property had 
already been destroyed, but the facts were not known either to the 
insurer or the insured. This is taken care of by the phrase “lost or 
not lost,” included in the description of the property insured. 

A third contrast with the usual practice in fire insurance is the 
rule with regard to constructive total loss. A constructive total 
loss occurs when the property insured is not physically destroyed, but 
is so situated that the cost of rescue or repair would be greater than 
the value of the property. Notice of intent to claim a constructive 
total loss is given through “notice of abandonment,” an offer on the 
part of the insured to abandon the property to the insurer in return 
for payment of the face of the policy. Such notice does not obligate 
the insurer to accept abandonment, nor does it release the owner from 

1 See p. 293. 


322 


RISK AND RISK-BEARING 


the obligation to exercise reasonable care to preserve whatever value 
may remain; it merely evidences good faith in claiming a constructive 
total loss. 

A very wide range of special clauses and special types of policy is 
offered. “Voyage” policies cover a definitely described voyage; 
“time” policies cover vessels for a stated period. “Fleet” insurance 
covers a large group of vessels by a blanket policy. “Builders’ risk” 
policies provide protection during the construction or repair of vessels. 
Cargoes may be protected by “named” policies, which designate 
the vessel to be used, by “floating” policies, which designate merely 
the voyage and type of vessel, or by “open” policies which cover all 
the shipments made by a given firm within the life of the policy. 

The rates in marine insurance are highly unstandardized, competi¬ 
tive, and unstable. There is no such thing as schedule rating. There 
is a very limited body of statistical data from which to estimate the 
risk, and such facts as have been gathered are closely guarded by the 
individual companies as trade information. Moreover, the moral 
hazard is very great, and even in the absence of fraud or deliberate 
carelessness the loss experience of different operators varies widely. 
Consequently, the element of judgment enters to a greater extent than 
into almost any other type of insurance. 

Tornado insurance is written in connection with fire insurance, 
and is very popular in sections of the country which are subject to 
disastrous wind storms. The general provisions are similar to those 
of the standard fire insurance policy, but the contract is simpler for 
the reason that there is no moral hazard, and no need of special pro¬ 
vision to secure proper protective measures on the part of the owner 
or tenant. Coinsurance is commonly required, where state laws per¬ 
mit, as the proportion of partial losses is extremely high. 

This type of insurance should always be written by a large stock 
company covering a very wide territory. Local mutuals are in an 
especially weak position with regard to this sort of coverage, for a 
severe storm may cause partial loss on nearly every property in its 
path, with numerous cases of total loss; an insurer must have a very 
large field of business in order to secure an adequate distribution of 
risks. 

Automobile insurance.—The rapid increase in the use of the auto¬ 
mobile, for purposes both of business and pleasure, has created a 
demand for this new type of insurance. About 30 per cent of the 


MISCELLANEOUS PROPERTY INSURANCE 


323 


automobiles in the United States, it is estimated, are covered by one 
or more of the standard types of policy, of which the most important 
are the following: ( a ) Liability insurance; this policy protects the in¬ 
sured against legal liability and damages because of personal injury to 
others arising out of the use of an automobile. ( b ) Property damage 
policies protect against injury to the property of others which may 
result from accidents in connection with the use or ownership of an 
automobile, (c) Collision insurance protects against injury to the car 
owned by the insured, resulting from collision with other cars or with 
any other object. ( d ) Fire insurance policies are very similar to those 
written on buildings and other property, as described in chapter xiv. 
(e) Theft insurance protects against loss of the car, or of its parts or 
accessories. 

In these types of insurance, there is a wide difference in the rates 
charged in different territories, on different types of cars, and under 
different conditions of use. For instance, the rate for public liability 
insurance on a certain car ranges from $103 in the district rated highest 
to $19 in the district rated lowest; theft insurance in one territory 
ranges from $6.35 per $100 on one car to $25 on another. 1 

Crop insurance is a highly speculative type, because of the extent 
to which losses are likely to be coincident for a large number of policy¬ 
holders; the insurer finds it difficult to secure a proper distribution 
of the risk. Moreover, in the present organization of the business 
there is a considerable moral hazard. The best established form is 
hail insurance, which has been of considerable importance for the 
past twelve or fifteen years. The total premiums paid for hail insur¬ 
ance in 1919 amounted to $30,000,000; the total insurance in force 
to $560,000,000. 

General crop insurance has been attempted in only a few instances. 
During the war there were a number of cases of price insurance in New 
England, but these were effected through associations of public-spirited 
citizens as a means of encouraging increased agricultural production, 
and not as a business carried on for profit. 

In 1917, three insurance companies operating in the northwest 
offered insurance against crop failure. This experiment turned out 
badly for the insurers on account of drouth and failure to provide 
properly against the assumption of risk after damage had already taken 
place. 

1 Riegel and Loman, Principles of Insurance , chap. xx. 


324 


RISK AND RISK-BEARING 


In 1920, two companies again offered crop insurance—one of 
them including in its coverage protection against loss due to decline 
in the market value of the crop; an experiment which proved very 
costly on account of the slump in grain prices of that year. Various 
forms of protection are now offered in limited territories, but this 
form of insurance is still in its experimental stage and the outcome is 
doubtful. 1 

Credit insurance is a comparatively new type of indemnity, which 
is offered by three leading companies. The object of this kind of 
insurance, as its name indicates, is to protect business men (whole¬ 
salers and manufacturers) against the risk of extraordinary losses due 
to insolvency on the part of their debtors. 

The policy offered contains a number of distinctive features. 
In the first place, the insured must bear a stipulated initial loss 
before the insurer has any liability. This amount is known as the 
normal loss, and is figured on the basis of the average loss ratio to 
gross sales for the preceding five years. Second, the maximum 
amount which will be paid on account of a single loss is restricted 
to an agreed percentage of the customer’s capital rating as supplied 
by a reputable mercantile agency. Third, the principle of coinsurance 
is applied, but in a manner somewhat different from that used in fire 
insurance. In the case of customers who have first credit ratings, 
the insured carries 10 per cent of the loss; in the case of those who 
have a lower rating, 33J per cent. The insured cannot, as in fire 
insurance, get rid of this residual risk by insurance with another 
company. Fourth, the total liability of the company is usually, but 
in the newer policies not always, limited to a stipulated maximum. 
Fifth, the losses covered are those which arise from insolvencies 
which occur during the life of the policy or within 15 days there¬ 
after. Insolvency is defined very broadly for purposes of the policy, 
however, including death or disappearance of the debtor, assign¬ 
ment by the debtor, recording of a chattel mortgage on his 
property, etc. 

Judged by the total amount of losses incurred, the hazard of losses 
through insolvency of debtors is comparable in importance to the fire 
hazard, as is shown by the following table: 

1 V. N. Valgren, “Crop Insurance,” Bull. U.S. Dept, of Agriculture, No. 1043, 
January 23, 1922. 


MISCELLANEOUS PROPERTY INSURANCE 


325 


Failure and Fire Losses for 10 Years* 



Failure Loss 

Fire Loss 

IQ 2 I. 

$750,200,000 
426,300,000 
115,500,000 
137,900,000 
166,600,000 
175,200,000 
284,100,000 
357,100,000 
292,300,000 
198,900,000 

$ 332 , 654,950 

330,853,925 

269,000,775 

290,659,885 

250 , 752,640 

214 , 530,995 

172,033,200 

221,439,350 

203 , 763,550 

206,438,900 

1020. 

IQIQ. 

IOl8. 

IQI 7 . 

IOl6. 

1915. 

IQI 4 ... 

IOI 3 . 

1012. 

Total. 

$2,904,100,000 

$2,492,428,170 



*Huebner, Property Insurance, p. 526. 


It is not sound to argue from these figures, as has sometimes 
been done, that the business man’s need of credit insurance is com¬ 
parable to his need of fire insurance. The test of the desirability of 
any form of insurance is the unpredictable character of the loss, not 
its total amount. Whereas the fire losses are concentrated in a very 
high degree, so that only a small minority of business men suffer fire 
loss in any given year, and that minority suffer very heavily, the risk 
of loss from bad debts is widely distributed, falling in some degree 
upon nearly everyone who extends credit, in every year. In so far 
as the loss from bad debts runs the same from year to year, it can be 
taken care of as one of the regular costs of doing business, and there 
is no more need of insurance against it than against any other expense. 
It is in recognition of this fact that the limitation of liability ,to loss 
above a stipulated normal is included in the provisions of every credit 
policy. Were this not done it would be necessary to increase the 
premiums by a large fraction of the normal loss 1 and there would also 
be a significant increase in the moral hazard. 

The regularity of credit losses in the individual experience, as 
compared with the experience with fire, arises from the fact that the 
business man nearly always has a better distribution of his credit risk 
than he has of his fire risk. With a few hundred accounts the opera¬ 
tion of the law of large numbers assures a high degree of regularity 
in so far as the risks are independent. The chief protection afforded 

1 Not, however, as has sometimes been stated, by the full amount of the 
normal loss. The added amount of claims to be paid would never equal the amount 
of the normal loss on all the policies, as there are always some policies on which 
the loss in a given year is below the normal amount. 






















326 


RISK AND RISK-BEARING 


by the policy is against the hazard of crisis, which corresponds in 
credit insurance to conflagration hazard in fire insurance. The busi¬ 
ness man is really in the position of the small fire insurance company, 
rather than in that of the holder of a few pieces of exposed property. 
The insurance company reinsures if it has a few risks too large to be 
carried safely in dependence on the working of the law of averages, or 
if it gets too many risks exposed to the hazard of a single conflagra¬ 
tion; likewise credit insurance is chiefly valuable in guarding against 
the crisis hazard, or in protecting a line containing a few dispro¬ 
portionately large risks. Whether the crisis hazard is great enough 
to justify insurance of a well-balanced line of credit risks is a question 
in regard to which opinions may well differ, as the crisis hazard itself 
changes from year to year. That the hazard is still far from negligible 
is indicated by the experience of the leading credit insurers, which 
showed losses amounting to 3 per cent of premiums in 1919 and 89 
per cent in 1920. 

Miscellaneous Property Insurance. Other standard types of 
property insurance, which it is not necessary to describe in detail, 
cover such varied hazards as personal accidents; burglary and theft 
or personal property; breakage of plate glass (in this case the company 
agrees to replace the glass or pay its actual value, so that there is no 
limit to the company’s liability in case the glass advances in value 
after the policy is written); steam boiler explosion (which involves 
a much larger element of prevention of loss than do most types of 
insurance); electric engine damage; water damage; sprinkler leakage, 
etc. 


CHAPTER XVI 

GUARANTY AND SURETYSHIP 

I. INTRODUCTION 

The type of specialization which involves the assumption of risk 
by a specialist who believes that he can foresee the outcome of a 
venture and decides that there is no risk, or a smaller risk than is 
generally estimated, finds most of its illustrations in speculation. 
Outside this field, illustrations are found in contracts of guaranty and 
suretyship and in certain types of so-called insurance which are really 
more properly considered as surety arrangements. For instance, a 
title insurance company guarantees real estate titles, not by figuring 
the percentage of losses and calculating a premium to cover the risk, 
as is the insurance practice, but by searching the records until it is 
satisfied that no risk exists. For the private individual who cannot 
conduct this investigation for himself, the contract removes an impor¬ 
tant risk; for the company the risk is negligible. 

So with individual guaranties. When a friend signs a card to 
enable one to draw books from a municipal library, he does not inquire 
what per cent of guarantors are called upon to make good the losses 
sustained by the library; he depends absolutely upon his friend’s per¬ 
forming his obligations, though he is doubtless aware that some people 
do not do so. He believes his friend is individually a safe risk, what¬ 
ever the average may be. The library, not sharing this faith, considers 
that the guaranty reduces a real risk. 

In the same way, when A indorses B’s note as an accommodation 
he may know perfectly well that i per cent of the business men in the 
United States are likely to fail within a year, but he does not figure 
that he is running a i per cent risk; he believes B is all right and will 
not be among the i per cent. If he had any doubt about it, he would 
probably decline to furnish the indorsement. A bank acceptance 
is exactly the same sort of transaction. The bank accepts drafts 
drawn on it on account of a customer, depending on him to provide 
the necessary funds before the draft falls due. It does not charge 
an actuarial premium based on statistics of risk; it merely charges a 
commission for the service. Unless it considers itself safe it does not 
accept the draft. To the drawer of the draft, who does not share the 


327 


328 


RISK AND RISK-BEARING 


bank’s knowledge or its confidence in the customer’s reliability, the 
bank’s acceptance makes the transaction less risky. 

In foreign-exchange transactions certain individuals or firms of 
excellent standing buy the paper of small firms which have not estab¬ 
lished their reputation, add their own indorsement and resell the paper 
in the open market at a higher price. They know, or at least they are 
convinced, that the less-known firms are sound; but the general public 
not being so fully informed, the well-known indorsement adds to the 
market value of the paper. Here again we have a reduction of risk 
through specialization in securing more adequate information than 
is generally available. 

The ordinary practice of underwriting 1 security issues involves a 
similar principle. An investment banking-house or a syndicate 
guarantees the sale of an issue of securities, often knowing in advance 
exactly where the buyers are to be found; and in other cases consider¬ 
ing that there is no significant risk of failure to dispose of the issue. 
The commission is indeed often in part an actuarial premium for risk 
undergone, but it is chiefly a compensation for service rendered in 
investigating the proposal and in facilitating the sale by its indorse¬ 
ment. 

Of the numerous ways in which business men transfer risk to 
specialists who do not carry a corresponding risk, because of superior 
knowledge or because of ability to prevent losses, two are selected 
for detailed examination, corporate suretyship, and the protection 
of buyers of real estate against defects in titles. 

II. CORPORATE SURETYSHIP 

Corporate suretyship has been described as follows: 

The business of suretyship as defined in the insurance law of New 
York is: 

1. Guaranteeing the fidelity of persons holding positions of public or 
private trust. 

2. Guaranteeing the performance of contracts other than insurance 
policies. 

3. Executing or guaranteeing bonds or obligations in actions or pro¬ 
ceedings or by law allowed. 

It will be seen from this that, in a general way, except as to insurance 
policies, a surety company may, and generally will guarantee that a particu- 

1 The term “underwriting” is here used in its narrower meaning of guaranteeing 
a sale, as distinguished from the loose usage of the term as equivalent to outright 
purchase for resale. 


GUARANTY AND SURETYSHIP 


329 


lar principal will do any lawful thing specified, provided the security is 
satisfactory to the surety company and a reasonable compensation is paid. 
To really understand suretyship, one must separate fidelity insurance from 
the other branches. Fidelity insurance is handled as any other line of casu¬ 
alty insurance would be, and while reliance is placed upon salvage, neverthe¬ 
less the real reliance is upon the fact that only a certain very small proportion 
of men are likely to be dishonest. It is accordingly underwritten as an insur¬ 
ance proposition. All the other lines, sometimes specifically spoken of 
collectively as surety lines, are, however, underwritten upon the theory that 
there is a sound and competent principal who will perform the condition of 
the bond; and the surety does not seriously contemplate the possibility of 
being required to pay the bond, but considers that what he furnishes in return 
for the fee paid is merely a service. In other words, by signing the bond as 
surety, he extends credit to the principal. Suretyship is just as much the 
granting of credit as is banking, the only difference being that the bank 
furnishes to its customer the use of current funds, while the surety furnishes 
its customer with the opportunity to do something which he otherwise 
would not be able to do, or enables him to avoid the necessity of doing 
something until the contingency occurs which makes it certain he must do it. 1 

Formerly, it was the custom for individuals who were called upon 
to furnish bond for any purpose to make application to individual 
friends and acquaintances, as is still the practice for the most part in 
furnishing bonds for appearance of alleged criminals to answer charges 
against them. For most purposes, however, the advantages of cor¬ 
porate suretyship are so great that, within the fifty years since it was 
introduced in this country, it has almost entirely supplanted the sys¬ 
tem of individual suretyship except in criminal business and in the 
furnishing of surety for the payment of small promissory notes. 

Corporate suretyship offers several very distinct advantages over 
the system of individual guaranties. In the first place, it substitutes 
an impersonal business relationship for personal accommodation. The 
result of this is that the assured is relieved of embarrassment and from 
a sense of obligation to reciprocate. Moreover, especially in the case 
of bonded public officials, individual suretyship may create an oppor¬ 
tunity for the guarantor to exercise pressure in the direction of an 
undesirable use of official discretion. Finally, the courts are prone 
to be very lenient in interpreting responsibility of individual guaran¬ 
tors when they are called upon unexpectedly to fulfil an obligation. 
In the second place, corporate suretyship affords a better security, 

1 Adapted from advertising literature published by the American Surety 
Company, New York, 1919. 


330 


RISK AND RISK-BEARING 


for the resources of the insurer are much larger in proportion to the 
requirements of any one bond than is likely to be the case with individ¬ 
ual guarantors. 

The types of bonds usually written by surety companies may be 
described as follows i 1 

Fidelity bonds protect employers against breach of trust and also 
in some cases against negligence. In writing this insurance, great 
emphasis is placed upon such factors as character, family connections, 
income, standards of living and associates, yet the number of losses is 
very great. Most of these losses apparently arise from one of three 
sets of conditions: first, extravagance and dissipation; second, specu¬ 
lation and gambling; third, loose accounting and mingling of 
employers’ funds with personal funds. 

Fiduciary bonds cover the liability of trustees. The most impor¬ 
tant are those given in probate proceedings and in insolvency. In 
these, as in most of the types of suretyship hereafter enumerated, the 
moral risk is relatively small, but there are many opportunities for 
the insurer to become involved in liability on account of carelessness 
or ignorance concerning his very technical obligations. 

Public official bonds are required in most cases where individuals 
are intrusted with the care of public funds. The liability under this 
form of suretyship usually extends to any responsibility which may 
attach to the principal on account of negligence or ignorance, as well 
as actual breach of trust. 

Judicial bonds are given chiefly by defendants to stay execution, 
and pay judgments; sometimes to cover the liability of plaintiffs for 
wrongful pursuit of a remedy to which they are not entitled. 

Criminal bail bonds guarantee the appearance of a defendant for 
trial. The moral hazard in this sort of suretyship is of course very 
great. It is usual, therefore, to require that the principal deposit 
collateral security with the insurer to cover its liability. In some cases, 
the courts refuse to accept such bonds on the ground that a bondsman 
who is fully secured has no incentive to produce his principal for trial; 
hence the probability of forfeiture is too great to be consistent with the 
public interest in securing the actual appearance of the defendant. 

Admiralty bonds are given by owners of vessels to secure the pay¬ 
ment of claims and damages, in order that the vessels may not have 

1 The following description is based in part on Corporate Suretyship , an address 
by First Vice-President R. R. Brown, of the American Surety Company of New 
York, to the department of economics and social institutions of Princeton Uni¬ 
versity (pamphlet, reprinted from the Weekly Underwriter , New York, not dated). 


GUARANTY AND SURETYSHIP 


331 


to be held within the jurisdiction of the court while a case is awaiting 
trial, and by the owners and consignees of goods which are likely to 
be held liable for a contribution on account of the loss occasioned by 
the jettison of other parts of the cargo or of parts of the vessel’s rigging 
and equipment. 

Depository bonds secure the repayment of deposits by banks; 
usually deposits of public funds. 

Customs and internal revenue bonds are written in many forms. 
They secure the observance of revenue laws and regulations, or the 
payment of customs duties on goods released from the control of 
customs officials. Goods intended for re-export, for instance, may be 
covered by a bond guaranteeing the payment of duties in case they 
are not actually shipped out. 

Warehouse bonds guarantee the performance of duties by ware¬ 
housemen. Their purpose is chiefly to enable the owner of goods 
in storage to secure credit on the security of the goods. 

License , occupation , and permit bonds secure the observance of 
law by persons engaged in regulated occupations, such as plumbers, 
saloon-keepers, bonded abstracters, etc. 

Contract bonds secure the performance of obligations under con¬ 
tract. This is a very large and important class of surety obligations. 
Bonds are required in connection with nearly all large construction 
enterprises. Such bonds are very hazardous because of the numerous 
circumstances which may occasion default on the part of a building 
contractor, and the great expense involved securing the completion 
of an unfinished contract. Bonds are also required by the United 
States government in connection with the performance of mail service 
and the furnishing of almost every kind of supplies. Supply bonds 
involve chiefly the risk that the contract will become a source of loss 
on account of advancing prices; contracts for the performance of mail 
service are extremely hazardous, as specific performance is usually 
required. 

Lost security bonds indemnify a corporation in case of loss arising 
from the replacement of a lost instrument which is later found. Such 
bonds are always required when claim is made that a stock certificate 
or bond has been lost or destroyed. This type of bond involves very 
little risk to the bonding company. 

III. INSURANCE OF REAL ESTATE TITLES 

The title to real estate affords an excellent illustration of the possi¬ 
bility of reducing risk through research. To the average man without 


332 


RISK AND RISK-BEARING 


expert assistance, the elements of risk involved in a purchase of real 
estate on a simple warranty deed are very great. Years after the 
property has been paid for and large sums have been spent in its 
improvement, a defective title may result in an actual loss of posses¬ 
sion, or, more frequently, a clouded title may necessitate expense in 
order to clear up the doubt. On the other hand, if sufficient care is 
taken it is almost always possible at any given time to discover all the 
flaws in a title, and enable a purchaser to take the property with very 
little risk. Three principal methods accomplishing this purpose are 
in use in the United States. 

Bonded abstracters .—The simplest system is the employment of a 
bonded abstracter. Under this plan, the buyer or the seller of property 
employs a professional abstracter to draw up an abstract of title, 
which is then submitted to an attorney for an opinion. The abstracter 
is legally liable if a loss occurs as the result of his failure so to prepare 
the abstract as to show the facts of record concerning the title, and 
is heavily bonded to insure the payment of such damages. 

This system is widely used in the rural sections of the West and 
works satisfactorily in the great majority of cases. (Indeed any sys¬ 
tem works satisfactorily in the majority of cases for the reason that 
there are usually no unknown defects of title which can cause trouble 
no matter what system of protection is employed.) The system is 
incomplete, however, for there are numerous possible defects which 
are beyond the field of the abstracter’s investigation—for instance a 
forged deed may be recorded and the abstracter will have no way of 
detecting the forgery, or there may be an undiscovered heir whose 
rights are not a matter of record. Moreover, there is always the risk 
that careless reading of the abstract or inefficient advisory work by 
the attorney may cause a loss in cases where the abstract actually 
discloses a flaw in the title. Finally, in the older sections of the 
country, where transfers have been numerous, the mere physical labor 
of searching records and copying abstracts makes this method unduly 
expensive. 

Title insurance .—In these older sections, especially in cities, the 
most popular method of dealing with title risks is through the services 
of a title insurance company. Such a company usually has a virtual 
monopoly of the business in a limited territory and therefore operates 
on a sufficiently large scale to justify the expense of maintaining 
elaborate files, from which the information necessary to pass on a 
given title can be obtained quickly and economically. 


GUARANTY AND SURETYSHIP 


333 


The policy, which is perpetual in its force, insures not only against 
the establishment of an actual defect in the title, but also against any 
expense which may be involved in defending title, and against any 
damage which may be sustained because of the refusal of a buyer to 
accept the property on account of alleged defects in the title. 

Before issuing such a policy, the insurer makes a careful examina¬ 
tion of the records and lists in the policy all known defects, and also 
certain possible unknown defects which are not matters of record. 
Loss from these listed defects is then excepted from the protection of 
the policy. Thus the policy serves the double purpose of a report on 
the existing state of the title and a guarantee against loss due to error 
and omission in the report. 

The essential difference between the protection afforded by such a 
policy and that afforded under the bonded abstracter system is that 
in the latter case protection extends only to the result of negligence 
or wilful error on the part of the abstracter, while in the case of the 
title quarantee company it extends to numerous potential defects 
which are beyond the possible knowledge of any of the parties to the 
contract. The more important of the possible flaws which are not 
discoverable through searching of the records are excepted from the 
provisions of the policy, however, so that the risk actually taken by 
the company is very small. 

The following quotations from the form used by a prominent 
title insurance company indicate the character of the protection 
afforded: 

The X Title and Trust Company shall have the right to, and will, at its 
own cost and charges, defend the party guaranteed in all actions of eject¬ 
ment or other action or proceeding founded upon a claim of title, incum¬ 
brance or defect, which existed or is claimed to have existed prior in date to 
this policy and not excepted herein; reserving, however, the option of set¬ 
tling the claim or paying this policy in full. 

Loss or damage by reason of special taxes or special assessments which 
have not been confirmed by a court of record, conveyances or agreements 
not of record at the date of this policy, or mechanics’ liens when no notice 
thereof appears of record are not covered by it. 1 

In addition to the limitation of liability just quoted, each policy 
contains a special schedule of “ estates, defects or objections to title, 
and liens, charges and incumbrances thereon, which do or may now 

1 The quotations are from the form used by a western company. For full 
standard form adopted by the New York Board of Title Underwriters, see Huebner, 
Property Insurance (revised), pp. 513-19. 



334 


RISK AND RISK-BEARING 


exist, and against which the Company does not guarantee.” The fol¬ 
lowing quotations from this schedule in a recent policy are typical: 

1. Conditions contained in the deed made by John E. Brown and wife 
to Margaret A. Short dated November 5, 1894, and recorded November 5, 
1894, as document 218475, that no building shall be placed on the east 
thirty-five feet of the premises in question. 

2. Party wall rights, if any. 

3. Special assessment warrant 36783 for paving Johnstone Avenue, 
confirmed March n, 1919, for $108.63 on premises in question, payable in 
five installments, the last four unpaid. 

4. Taxes for the year 1920. 

Title policies are not assignable, except when issued to protect 
mortgages. At each transfer a new policy is issued to protect the 
new buyer. The cost of subsequent policies is considerably less than 
that of the first, as little work has to be done to bring the record down 
to date. 

The losses paid by title insurance companies are far smaller than 
is the case with any other type of insurance; indeed in many cases 
purely nominal losses are sustained for years at a time. The premium 
is based on the service rendered in searching the title rather than on 
the risk assumed. Nevertheless, though the amount lost on account 
of defects which are not discovered through searching records and are 
not excepted (such as forged deeds, spurious powers of attorney, deeds 
executed by lunatics, undiscovered heirs), the loss in the few instances 
where such flaws exist is likely to be very serious for the persons con¬ 
cerned, and a system by which such risks are transferred at small cost 
to a responsible insurer provides a real social gain. 

The Torrens system .—A third method of furnishing security against 
defects in title, which has been introduced in recent years in certain 
parts of the United States, is the so-called Torrens system. This is a 
system of public registration whereby at each transfer of title the pur¬ 
chaser is given either an indefeasible title or a guarantee of reimburse¬ 
ment in case the title proves defective. 

In the original Torrens system, which was established in Australia 
in the latter fifties, an administrative body was authorized to search 
the title, and in the event that no defect appeared, the claimant in 
actual possession was given a certificate entitling him to absolute 
ownership. A small assessment on all property registered under this 
system provided a fund from which compensation was made to any 
holders on unsatisfied claims who might be deprived of their rights 
through such registration. 


GUARANTY AND SURETYSHIP 


335 


The system has had a limited application in England and a con¬ 
siderable popularity in Canada, and within the last few years has been 
adopted in modified form in about a dozen American states. Under 
the law of some of these states, registration does not give an inde¬ 
feasible title, and the fund provided by registrants is used to compen¬ 
sate holders of the registration certificates, in case error is discovered, 
instead of previous holders of title as under the original Torrens sys¬ 
tem. In other states, the registrant is given an indefeasible title, but 
this is done through a formal suit to clear the title, and not through 
the action of administrative officers. 

In theory, the principle of the Torrens law provides a distinct 
improvement over any of the other systems. It does not seem neces¬ 
sary that in a community where land has been held by private individ¬ 
uals for many generations, investigators should at every transfer 
review the entire history of the title and reopen the question of the 
validity of each alleged transfer, as is the practice under the bonded 
abstracter system. Nor does it seem an ideal system that the com¬ 
munity should depend for so essential a service upon the preservation 
of the records of a private company and the maintenance of its ser¬ 
vices, as is the case where the title insurance system is used. The 
Torrens system, by clearing the slate at each transfer, greatly sim¬ 
plifies the whole question. 

In most cases, the initial expense of registration is somewhat 
greater under the Torrens system than in the guarantee of title by a 
title insurance company, and this cost falls upon a seller who has no 
interest in the economy which will result in connection with future 
transfers. For this reason, possibly also because of the influence of 
the title companies, and also because of administrative weaknesses 
and doubts in some quarters as to constitutionality, the progress of 
the Torrens system in America has been slow. The only places in 
which it has apparently had a significant development are Cook 
County, Illinois, and the state of Massachusetts, and even there, so 
far as volume of business is concerned, it is overshadowed by the title 
insurance companies. 


CHAPTER XVII 
RISKS OF LABOR 

I. INTRODUCTION 

As was indicated in chapter iii, the present industrial organization 
contemplates the transfer to the business man of certain of the risks 
associated with production, and a corresponding increase in the secu¬ 
rity of the other factors in production. Under all ordinary circum¬ 
stances, the laborer can count on receiving his pay for his co-operation 
in an enterprise quite regardless of the ultimate success of the enter¬ 
prise. Not only does the employer’s capital stand between the laborer 
and the risks which beset the productive process, but to a large extent 
those who extend credit to the business manager in any other way have 
their claims subordinated to those of the laborer. 

Nevertheless, the position of the worker is never free from certain 
elements of risk. This arises in part from the impossibility of framing 
a labor contract in such a way that all the risk of the business is borne 
by the management, and secondarily from the fact that the worker 
must himself carry the risk of being unable to find continuously an 
opportunity to enter into an advantageous contract for the selling of 
his labor. A group of students of the labor problem have summarized 
the situation as follows: 

To carry the analysis into the field of labor, the worker, if he learns a 
trade, takes the risk that the demand for his services will be inadequate to 
give him full-time employment at a living wage; he takes the risk that there 
may be more workers in the trade than can be employed; he takes the risk 
of changes in the technique of production eliminating the need for his skill 
and throwing him into competition with myriad unskilled workers; he takes 
the risk of being injured or becoming infected by occupational disease; he 
takes the risk of being made a nervous wreck by the “roar and rhythm” 
of the machine; and always there is the risk that public demand for the 
product in the manufacture of which he is engaged may cease and leave him 
out of a job, unfitted to do the work demanded in other lines of industry. 

Labor trouble is a source of danger to the business manager, but it also 
threatens the worker. If he goes on a strike to better wages or working 
conditions he runs a chance that the organization of which he is a member will 
not be strong enough to win the strike or that strike benefits will be insuffi- 

336 


RISKS OF LABOR 


337 


cient to keep himself and his family alive. If the strike arouses public ill will, 
anti-labor legislation may limit freedom of action on the part of labor organi¬ 
zations thus tending to perpetuate the uncertain conditions against which he 
went on strike. 

And so it goes. Inadequate income whether due to unemployment, 
industrial old age, sickness, accidents, industrial conflict, or low wages Bring 
risks of undernourishment which brings the risk of impaired efficiency which, 
if it occurs, increases the risks of accident, disease, and low wages. Children 
brought into the world may have to grow up under the handicaps imposed 
by such risks and this adds another risk to the already heavy load of uncer¬ 
tainty which the worker has to bear. 

Indeed it can be said with a certain degree of accuracy that the worker 
assumes all the risks of the employer and in addition bears some unique 
to himself. In common with all individuals he runs the risk of death, acci¬ 
dent, fire, -war, disease, etc., the risks due to his carelessness which includes 
many accidents and deaths, and the risks due to the dishonesty on the part 
of the worker or others; as a member of the working class he bears the unique 
risks of unemployment, underemployment, or overemployment, long hours, 
the risk of inadequate wages, the risks arising out of the antagonism between 
specialists, the risks of specialization, the risks due to the characteristics of 
the machine, the risks of anti-labor legislation, and the risks of competition 
from his fellows; in particular industries he runs the risk of seasonal employ¬ 
ment, of occupational disease, of sweating, of accidents, or moral devolution. 1 

The risks which the laborer shares with the rest of the race we 
may well leave without detailed consideration. Our particular inter¬ 
est is in the risks which arise directly from his connection with the 
economic process. Of these by far the most important are the risks 
of unemployment and of industrial accident and occupational diseases. 

II. UNEMPLOYMENT 

Exact figures for the volume of unemployment are not available , but 
the estimates made by competent investigators agree in showing, first, 
a high degree of variability in the amount of unemployment, and, 
second, an appreciable amount of unemployment at the busiest sea¬ 
sons of the most prosperous years. Omitting agricultural labor from 
consideration, it appears that during the last twenty years the amount 
of unemployment in the United States has fluctuated from a probable 
minimum of 1,000,000 to a possible maximum of 6,000,000, out of a 
total number of workers estimated as about 30,000,000 during the 
latter part of the period. To some extent, the significance of the 

1 From Douglas, Hitchcock, and Atkins, The Worker in Our Modern Economic 
Society (preprint, chap. v). The University of Chicago Press, 1923. 


33§ 


RISK AND RISK-BEARING 


maximum figures is reduced by the probability that a considerable 
expansion of agricultural employment coincided with the minimum 
of industrial employment, but the extent of this absorption of the 
unemployed has not been estimated. 

The distribution of the cost of unemployment is very uneven. —In the 
case of approximately half the working group, the loss due to this cause 
is negligible, while within the other half there are very wide individual 
variations. 

Unemployment is a market risk. —Each manual laborer has to sell 
a definite amount of labor service, each item of which represents an 
irreplaceable impairment of his stock in trade. At the outside, the 
manual laborer can rarely sell more than twelve thousand days’ 
service during his working life; the average figure is probably 
nearer six thousand. Unemployment is simply the failure to market 
a part of his stock in trade. The seriousness of this hazard arises 
fundamentally from the fact that his labor is a “perishable com¬ 
modity.” Every day’s service must be sold at a given time or not 
at all. 

The difficulty is aggravated by the inelastic character of the price 
of labor. In times of slack demand, it would frequently be to the 
laborer’s immediate interest to sell his time at a cut price, just as a 
merchant finds it advantageous to clear his shelves by bargain sales, 
but the market is so organized that, as a rule, the laborer cannot, by 
price-cutting, stimulate an increase in demand for his services. He 
can sell his time at the going rate demanded by his competitors or he 
cannot sell it at all. Some decline of wages takes place in time of 
declining demand,but to a large extent labor is “deflated” in periods 
of depression by a decrease in the amount of labor sold rather than 
by a decline in its price. 1 

1 This is much less true of agricultural than of industrial labor. Independent 
farmers lose by the decline of the price of their products, and the relationship 
between the employing and employed groups in agriculture is so close that even 
the hired laborer in this field of employment is relatively free from the risk of 
unemployment, and finds his wage fluctuating rather sharply with the level of 
prices for the products of the farm. 

Whether labor, as a whole, gains by this custom of holding up wages in times 
of dull business and accepting unemployment is doubtful. There can be little 
doubt that a sharp readjustment of wages downward, in times of liquidation, would 
contribute greatly to the shortening of the ensuing depression. Laborers who are 
most certain of employment would lose; those who bear the burden of unemploy¬ 
ment would gain; the net result for the time being would probably be a gain. 
Whether this gain would be offset by the difficulty of getting wages up again as 


RISKS OF LABOR 


339 


In any discussion of the causes of unemployment, a distinction 
should be maintained between the conditions which determine the 
amount of unemployment at any given time and those which deter¬ 
mine the selection of individuals to bear the burden of the unemploy¬ 
ment. The amount of unemployment in any industry is determined 
chiefly by conditions for which the workers in that industry are indi¬ 
vidually responsible to a trifling extent. 

Unemployment arises chiefly from six causes: (a) seasonal fluctua¬ 
tion in the activity of specific industries; ( b ) cyclical fluctuation in the 
activity of business in general, as well as of specific industries; (c) the 
necessity of maintaining a reserve of unemployed labor in order to 
insure the smooth working of the industrial machine, as was pointed 
out in chapter ii; ( d ) labor troubles; (e) interruption of production 
from causes peculiar to the individual establishment, such as fire, 
bankruptcy, consolidation of plants, shutdown for lack of transpor¬ 
tation or of raw material, overstocking with finished goods, and similar 
causes; (/) personal incapacity and inefficiency, and shiftlessness. 

The factor named last is not co-ordinate with the other five, how¬ 
ever, but overlaps them. The first five causes determine how much 
employment there shall be at a given time; the sixth helps to determine 
which individuals shall be left out. Assuming that the economic 
situation is such as to dictate the unemployment of io per cent of the 
labor supply, what determines which of the laborers shall make up 
this io per cent ? In part, the answer is, chance. Shutdown on 
account of fire, for instance, affects the efficient and the inefficient 
alike. Reduction of forces on account of decline in the volume of 
orders, on the other hand, gives opportunity for a sifting of the labor 
force, especially where the number of employees is large, with the 
result that personal characteristics play a very large part in determin¬ 
ing where the ax shall fall. Moreover, even in cases where the unem¬ 
ployment arises from conditions which affect a whole group of workers 
alike, the personal efficiency, the energy, and the co-operative spirit of 
the laborer determine in large part what shall be the duration of his 
unemployment. For the best workman, a position is usually to be 
found quickly; for the mediocre and the low-grade worker the loss 

business revived one can only conjecture; it is a question of the relative importance 
of bargaining power and actual productive value in determining wage scales. A 
system of very elastic wage scales would make it possible for industry to pay higher 
average wages than it can now pay; the inelastic system makes it somewhat easier 
to compel industry to pay as much as it can. 



340 


RISK AND RISK-BEARING 


of a job is much more likely to mean serious loss of time before employ¬ 
ment can once more be obtained. 

Not all the unemployment represents waste , either from the social 
standpoint or from that of the laborer. From the standpoint of soci¬ 
ety, the loss of time incident to maintaining an adequate reserve of 
labor, the unemployment incident to shifting laborers from time to 
time to more productive employment, and the time necessarily lost 
on account of seasonal fluctuations in business, are all parts of the 
cost of running the industrial machine, and are no more to be accounted 
wastes than is the time of laborers engaged in eating and sleeping. 

From the laborer’s standpoint, also, the loss of time incident to 
seeking and obtaining better conditions of work must be regarded as 
an investment rather than a waste. 

In like manner, the unemployment which is the result of labor dis¬ 
putes represents, from the standpoint of the laborer, an investment 
intended to increase the selling value of part of his labor time by sacri¬ 
ficing the income from a smaller part. If the labor market were 
perfectly fluid, such dissipation of labor power would represent a sheer 
waste, for it would be practicable for anyone who was dissatisfied with 
the conditions of his employment to transfer himself to another field 
where the compensation and conditions of work were more satisfactory. 
The labor market, however, is an imperfect market; it is not practi¬ 
cable for the laborer who believes himself ill paid to transfer himself to 
another employment without loss of time, direct money cost, and con¬ 
siderable risk. Consequently, the effort to improve those conditions 
by interruption of service may well be, from the individual standpoint, 
profitable. From the social standpoint, it represents a waste just in so 
far as there exists a better method of insuring the adjustment of wages 
to changing conditions of demand and supply in the labor field. Cer¬ 
tainly it is a cumbersome and expensive method of maintaining the 
relationship between wages in a given industry and the conditions 
which determine a fair wage in that industry; yet this loss cannot be 
labeled a complete waste till a better method of accomplishing its 
purpose is demonstrated to be practicable. 

Of the causes of unemployment enumerated, the seasonal fluctua¬ 
tion is the most important, so far as numbers indicate importance, but 
the significance of this factor is greatly lessened by the extent to which 
it is compensated, either by wage rates or by the possibility of making 
profitable use of the idle time. The extent to which dovetailing of 
employment is possible depends chiefly on the technique of the indus- 


RISKS OF LABOR 


341 


try, and on the extent to which the amount and time of the employ¬ 
ment is known in advance. Some occupations, such as coal-mining, 
unfit the laborer for the most accessible alternate employments; others, 
such as farming, do not interfere directly with the laborer’s fitness for 
a variety of other employments, but coincide in their slack and busy 
seasons with most of the occupations in which alternative employment 
could otherwise be secured most readily; others, such as teaching, 
dovetail well with numerous other occupations which furnish profitable 
employment during the slack season. 

The extent to which the rate of pay in any occupation adjusts itself 
to the worker’s necessity of losing time, on account of seasonal fluctua¬ 
tions, depends on two factors, namely, the extent to which dovetailing 
is usually practicable, and the degree of certainty in the unemployment. 
Any condition limiting the total amount of employment, if it is cer¬ 
tain, is fairly sure to be compensated for in the wage, but competition 
is not so effective in compensating for the uncertain but probable losses. 
Even if the wage in a given occupation adjusts itself so that the average 
compensation for a year’s service is sufficient to cover idle as well as 
working time, it would still be true that many individuals would suffer 
from less than average employment. Moreover, if the amount lost 
by each individual is highly uncertain, it is much more likely to be 
under- than over-compensated for the average worker. The effect of 
the unemployment hazard on wages is merely to keep them high 
enough so that workers are willing to take the risk; if even a minority 
of workers overestimate the amount of employment they are likely to 
have, the wage adjustment may be such as to leave the average worker 
the loser. In practice, the adjustment of wages to irregularity in the 
volume of employment seems to vary widely from industry to industry, 
being most accurate in cases like teaching where the idle time is known 
accurately in advance, and least satisfactory in cases where a high 
degree of irregularity combines with a low standard of fife and inade¬ 
quate appreciation of the risk on the part of the worker. 

Ways of dealing with the risk of unemployment are numerous .—• 
Private employment agencies and newspaper advertising serve to 
shorten the interval between jobs by reducing the amount of work 
necessary for worker and employer to get in touch with one another. 
Scientific labor administration, including such devices as job analysis, 
rating cards, and all administrative methods and policies which aim 
at the creation of harmony and a spirit of co-operation within an indus¬ 
trial organization—all these serve to reduce the turnover of labor, and 


342 


RISK AND RISK-BEARING 


incidentally the risk of unemployment. Public employment agencies 
aim to effect a more economical adjustment of demand and supply in 
the labor field than that effected by the private agencies. All plans 
for the stabilization of industry (with primary reference to the reduc¬ 
tion or elimination of the cyclical fluctuation) include, among their 
objectives, the reduction of the amount of unemployment which char¬ 
acterizes the depression stage. Diversification of one’s preparation, 
so as to make possible the dovetailing of employment, aids individuals 
to meet the exigencies of the situation. 

Finally, it remains to consider the possibility of dealing with this 
risk through insurance. In most respects unemployment presents a 
good example of the kind of risk for which insurance offers a satisfac¬ 
tory palliative. The incidence of unemployment is frequent enough 
to keep the laborer alive to the importance of provision against it; it 
is not so great in amount that insurance against it involves a prohibi¬ 
tive cost; it affects different individuals at different times and from 
different causes, so that (in spite of the concentration of losses occa¬ 
sioned by a downswing of the business cycle) the catastrophe hazard 
is not a serious bar to the underwriting of the risk. The moral hazard 
would be very great if full protection were offered, but the insurer 
could be protected against this danger, as in credit insurance, by • 
requiring the insured to bear a fixed “normal loss” and to coinsure for 
a fixed percentage of the remainder. Insurance to the amount of 50 
or 60 per cent of wages for unemployment beyond a certain number of 
days (the number varying with the industry) would hardly stimulate 
a significant amount of deliberate unemployment. 

The chief obstacle to the writing of such insurance arises from the 
wide variation in the hazard on different individual risks; the difficulty 
in measuring this difference; and the certainty of serious adverse 
selection in case such measurement is not effected and utilized in rate¬ 
making. If flat rates were charged, without attention to individual 
variations in employability, there would undoubtedly be a tendency 
for poor risks to insure and the good risks, the men who rarely have 
trouble in finding jobs, to carry their own risk. There is also to be 
considered the possibility that kind-hearted employers, confronted 
with the necessity of reducing forces, would deliberately select for 
dismissal those who were protected by insurance against unemploy¬ 
ment. For these reasons, the ordinary form of insurance, which looks 
to the self-interest of each individual to induce him to take out such 
insurance as he needs, does not meet the situation. 


RISKS OF LABOR 


343 


On the other hand, some method by which whole groups of laborers 
might be insured, without opportunity for adverse selection, might 
serve a very useful purpose. One device, which has been used for the 
purpose in a number of cases, and appears possible of wider service 
in this way, is insurance through the trade union. Membership in a 
union depends primarily upon other considerations, so that there is 
no tendency for the poor risks to predominate among the insured; the 
amount paid is small enough so that there is no incentive to malinger¬ 
ing, and the organization has better than average facilities for deter¬ 
mining the genuinemess of claims against it. 

The weakness of this method consists in the fact that the insurance 
feature of trade union policy is subordinate to other features, and is 
therefore likely to be sacrificed to attain some other end. In almost 
every instance where insurance benefits are offered by a trade union, 
the funds contributed by members for that purpose are commingled 
with those collected for other purposes, and are likely to be used for 
the promotion of ends which have no relation to insurance. From 
the typical trade-union official viewpoint, the insurance feature is a 
means of obtaining and keeping members, or collecting additional 
revenue from them, rather than a primary purpose of the organization. 
Were an attempt made to collect from the membership sufficient funds 
to cover adequately the risk of unemployment, the insurance feature 
would become so expensive as to weaken rather than strengthen the 
organization. 

It does not seem probable that the risk of unemployment can be 
removed by voluntary insurance, paid for by the workers, either 
through the trade union or through a commercial insurance company. 
There remain the possibilities of insurance at the cost of the state, of 
the employer, or of some combination of these with one another or 
with insurance at the cost of the worker. Subsidized public insurance, 
both voluntary and compulsory, has been tried in a number of Euro¬ 
pean countries, the most .notable experiment being that now carried 
on by the British government under the Unemployment Insurance 
Act of 1920 (an extension of the National Insurance Act of 1911). 
Under this system, the cost of insurance is borne jointly by the 
employer, the employee, and the state. This joint support removes, 
in large part, the fundamental objection to a system of insurance 
which does not adjust the premium to the known difference of hazard 
in the individual case. With about 60 per cent of the cost borne by 
the state and the employer, even the individual who believes himself 


344 


[RISK AND RISK-BEARING 


to be a high-grade risk will not be so likely to complain of being over¬ 
charged when he is required to pay at the same rate as is charged his 
less employable fellow-worker, though in the case of the best workmen 
even 40 per cent of the average loss is probably an overcharge. The 
compulsory feature secures for the insurer a proper distribution of 
the risk. The contribution of the state is offset, in part at least, by 
the saving in poor relief, both public and philanthropic, which results 
from the operation of the insurance fund, and the effect of public 
relief extended in this way is perhaps less demoralizing than would 
be the case if it were extended directly as poor relief. The compulsory 
contribution of employers is defended on the ground that the cost of 
unemployment incident to the operation of a given industry is a part 
of the cost of running the industry, and ought to be so assessed as to 
appear in the price of the product, or in the profit account of the 
employer. 

The weakness of the plan, aside from serious administrative diffi¬ 
culties, lies in the absence of any plan of merit rating by which the 
employer may be given an incentive to stabilize his operations, or the 
employee an incentive to increase his own employability. An insur¬ 
ance system which merely equalizes burdens is useful, but it falls short 
of its highest possibilities unless it does something to reduce the total 
amount of losses. It may be too much to expect that any practicable 
system of rating individual risks will give the worker more incentive 
than he now has to rise into the class of steady workers who are 
relatively free from the risks of unemployment, but in the case of the 
employer there seem to be distinct possibilities of gain in this direction. 
In the light of the great progress which has been made in recent years 
in the elimination of irregularities in the operation of industrial plants, 1 
compulsory unemployment insurance which fails to reward or penalize 
marked departures from the usual proportion of idle time fails of its 
highest potential usefulness. 

It may be added that the political organization of the United States 
makes it more difficult here than abroad to maintain a national system 
of unemployment insurance, with its necessarily minute research into 
local conditions; while state organization presents very undesirable 
aspects on account of the extent to which the employers of one state 
are in direct competition with those of another, while their employees 
are drawn from a common source and move freely from one state to 

1 For example, in this country by the Dennison Manufacturing Company 
and by the Joseph and Feiss Company. 


RISKS OF LABOR 


345 


another. Unemployment insurance under political control does not 
appear to be a probable development of the immediate future, in the 
United States. 

Another possibility of the reduction of unemployment is the delib¬ 
erate expansion of public works in times of depression. This plan 
offers the double advantage of equalizing the incomes of laborers, con¬ 
tractors, and others by furnishing them employment during periods 
of dulness in industry, and of offering a probability of economy, con¬ 
struction costs being lowest at such times. In so far as public works 
promise to serve a real social need when completed, and are at the same 
time not of so urgent a character as to make it inadvisable to wait for 
depression eras in order to undertake them, this plan is thoroughly 
sound. The chief difficulty in its practical application arises from 
circumstances similar to those which interfere with the concentration 
of construction work by corporations in times of low cost, namely the 
difficulty of financing enterprise at such times, or securing authorization 
to carry them forward. A time when general business is very slack 
and employment scarce is fairly certain to be a time when the burden of 
taxation is felt to be abnormally heavy, and legislatures and electorates 
are prone to economize at such times. Proposals to undertake heavy 
expenditures for purposes that are not urgent receive grudging 
support. 


III. ACCIDENT AND OCCUPATIONAL DISEASE 

The risk of industrial accident and occupational disease presents a 
problem both in social policy and in individual financial management 
which is very similar to that presented by unemployment. In each 
case there is a considerable element of risk which cannot be eliminated 
by preventive measures, and another considerable element which can 
be eliminated if proper incentives are given those who are responsible 
for the conditions under which industry is carried on, both employers 
and laborers. In each case the hazard varies greatly from one industry 
to another; and in each case the financial loss is divided between the 
employer, the public, and the laborers themselves. In each case the 
financial loss inflicted upon the majority is small enough so that no 
serious problem exists, while the loss in individual cases is so great as 
to make the hazard very serious. The variation of the risk from one 
individual to another, under like conditions of employment, is not 
as great as in the case of unemployment hazard, but is neverthe¬ 
less so great that it is necessary to take account, in the determina- 


346 


RISK AND RISK-BEARING 


tion of a wise policy, of the effect on the worker’s incentive to exercise 
his best efforts to reduce the hazard. 

The statistics of industrial accident are more complete than those 
for unemployment, and the loss shows a much greater degree of regu¬ 
larity from year to year. The number of fatal industrial accidents in 
the United States has been estimated at 25,000 for 1913, and 23,000 
for 1919; those involving four weeks or more of disability at 700,000 
for the former year and 575,000 for the latter. 

The burden of the loss from personal accidents is distributed in 
various ways. Much of it falls directly on the workers affected; 
another portion probably falls initially on the employer through the 
necessity of paying higher wages in the more dangerous occupations; 
another part is assumed by the public in the form of poor relief, and 
through the cost of maintaining machinery for adjudicating claims 
arising out of accidents; another part is shifted to employers and 
others who may be responsible through voluntary or compulsory pay¬ 
ment of damages, through payments under compensation laws, and 
through insurance against liability; some small part is distributed 
over the working group through the medium of private insurance. 
Some of these methods are of sufficient importance to warrant detailed 
examination. 

There is no evidence that wage rates adjust themselves accurately to 
the risk of accident. —It has been argued that there is little need of 
public action with a view to allocating the burden of accidents more 
equitably, for the reason that competitive wages can be depended upon 
to equalize this, as it does other differences in the attractiveness of 
different forms of employment. The weakness in this form of argu¬ 
ment is the assumption, first, that in practice the degree of risk asso¬ 
ciated with any form of accident is known to the parties to the wage 
contract well enough to make it a reasonable basis of adjustment of 
wages, and, second, in the assumption that even if such adjustment 
were effected the result would be to equalize the burden. It may be 
granted that if the number of accidents which will occur in each 
establishment could be predicted accurately, and were known to all 
prospective applicants for such employment, and all such appli¬ 
cants were rational in their choices, the wages paid would have 
to compensate the group as a whole for the total loss due to acci¬ 
dents, and the burden would fall either on the capitalists employing 
them, the consumers of the product of the industry, or, conceivably, 
on the public at large. Even then, as was pointed out in discussing 


RISKS OF LABOR 


347 


a similar situation in connection with the risk of unemployment, the 
result, in the absence of an effective system of insurance, would be to 
bestow extra compensation upon the majority who escape the hazard, 
and not to remove the burden from those who now suffer it. 

But the outstanding characteristic of the situation is the absence 
of certainty concerning the amount of loss which will be incurred, and 
the certainty of selection adverse to the workers. For if some workers 
overestimate and others underestimate the risk, it matters not whether 
the average estimate is too high or too low. The effective amount of 
risk is the risk as estimated by those who, in numbers sufficient to man 
the industry, are disposed to rate it lowest. Familiarity breeds 
indifference, so that those who best know the risks of a trade are most 
apt to ignore them. Notoriously, many men have an unin telligent faith 
in their own good luck; others shrink from being thought afraid; and 
many are ignorant of the hazards involved in the pursuits which they 
choose. These are the men whose choices determine the excess of 
wages to be paid in dangerous occupations; the services of the timid 
or even the intelligently cautious worker are rarely needed in occupa¬ 
tions where danger is really great. 1 

The accident risk is rarely covered by personal insurance by workers .— 
The same factors which obstruct any tendency for wages to adjust 
themselves to the hazard of a given employment also obstruct the 
progress of private insurance as a palliative. If workers underesti¬ 
mate the degree of risk in a given trade, they are not likely to pay the 
premiums demanded for insurance by an insurance company which 
must figure the risk conservatively high and add a loading for expense 
and profit. Moreover, in the absence, of a definite assurance that 
wages are high enough to compensate for the risk undergone, the 
effect of insurance at the expense of the workers is merely to equalize 
the burden they are assuming without adequate compensation; it 
increases the burden for the group as a whole. Casualty companies 
do write a considerable amount of personal insurance to protect against 
the risk of accidents, but this is carried chiefly by professional and busi¬ 
ness men rather than by laborers. 

Liability. —It was noted above that a part of the accident hazard 
is transferred to employers, or other responsible persons, through the 

1 Cf. A. S. Johnson, Introduction to Economics, pp. 205-7. A careful theoret¬ 
ical analysis of this question is found in R. M. Woodbury, Social Insurance, an 
Economic Analysis, pp. 56-70. Mr. Woodbury has also examined the statistical 
evidence, and concludes that the data are entirely inadequate either to prove or to 
disprove the existence of any tendency for wages to adapt themselves to the degree 
of risk. 


34§ 


RISK AND RISK-BEARING 


medium of voluntary or forced settlement of claims for damages. The 
original theory of the common law does not distinguish the responsibil¬ 
ity of employers from that of others; that is, they are responsible for 
such damages as may be caused directly by their fault or negligence. 

This liability was, during the course of the nineteenth century, 
subjected to further limitation on account of the application, in cases 
involving claims for damage done to workmen by their employers, 
of defenses which would not be available in similar cases where the 
plaintiff was not an employee. These are, first, the defense of con¬ 
tributory negligence, the essence of which is that in cases where negli¬ 
gence on the part of both employer and employee is shown to have con¬ 
tributed to bring about the accident, no damages can be collected; the 
fellow-servant doctrine, which holds that an employer is not respon¬ 
sible for damage done to his employees through carelessness of other 
employees; and the doctrine of assumption of risk, by which the 
laborer is held to have waived his claim to damages if he can be shown 
to have had knowledge of the special hazard and accepted employ¬ 
ment without a special agreement guaranteeing him compensation 
for such accidents as might result. The cumulative effect of these 
defenses was to make it extremely difficult and expensive for an 
employee to obtain compensation in such cases as make up the major 
portion of the accidents to which the laborer is exposed, and to place 
upon him the financial cost of numerous accidents which he could in 
practice do little to prevent. 

During recent years, the situation has been changed through the 
general adoption of one or the other of two reforms, known respectively 
as employers’ liability laws and workmen’s compensation laws. 

Employer’s liability legislation (widely adopted between 1885 and 
1910) is simply legislation designed to modify the liability of the 
employer, without abandoning the fundamental rule that the employer 
is responsible, just as anyone else is responsible, for the results of his 
own negligence. Some states have abolished the fellow-servant doc¬ 
trine; others limit its application to certain industries or exclude from 
its operation injuries due to the fault of certain classes of employees. 
There have been also various modifications of the doctrine of contribu¬ 
tory negligence, some states providing for a division of the financial 
responsibility, in cases where negligence is shown on the part of both 
parties; others placing the burden on the employer to prove contribu¬ 
tory negligence instead of requiring the employee to prove its absence, 
as was the case under the common law. 


RISK AND RISK-BEARING 


349 


The chief criticisms of the system of employers’ liability as modi¬ 
fied by legislation are, first, that it is unduly expensive in administra¬ 
tion (on account of the necessity of suits to establish responsibility 
in a large proportion of cases); second, that it fails to place properly 
the cost of the accidents for which neither employer nor employee is 
directly responsible; third, that it has in practice provided compensa¬ 
tion for only about one accident in eight so that the bulk of the cost 
of accident has remained with the working group, where its incidence 
has been most burdensome, and its effect least effective in stimulating 
remedial and precautionary effort. 

Workmen’s compensation .—During the years since 1910 a new 
principle has come to be widely accepted for dealing with this type of 
risk, known as the principle of compensation. The features which 
differentiate the compensation plan from the systems which preceded 
it may be summarized as follows: First, under compensation the pre¬ 
sumption is in favor of assessing the cost of an accident on the employer 
instead of on the employee. In cases where neither the employer nor 
the employee is guilty of negligence, employers’ liability places the 
cost on the employee; workmen’s compensation places it on the 
employer. Second, workmen’s compensation aims to provide, so far 
as possible, a fixed scale of benefits for each type of injury, the amount 
depending on the character of the disability, the amount previously 
earned by the injured worker, the existence or non-existence of depend¬ 
ents, and similar considerations. Third, compensation benefits are 
frequently made payable in the form of annuities, in order that the 
loss due to the death or permanent disability of the injured worker 
may be reduced by the replacement of his wages by a similar type of 
income; liability insurance, since it contemplates payment for a spe¬ 
cific wrong already committed, favors immediate payment of damages 
in a lump sum. Fourth, compensation plans frequently recognize 
the desirability of requiring employers to protect their employees 
from the risk that the purpose of compensation may be defeated by the 
employer’s bankruptcy or withdrawal from business. 

Beginning in 1910, the principle of compensation found very rapid 
acceptance, and only five states, together with the District of Colum¬ 
bia, 1 now have no compensation laws. In many of the states listed 
as having compensation, however, the number of occupations excluded 
and in the few cases the existence of optional substitutes, reduce con¬ 
siderably the significance of these figures. The following recent 

1 In privatejemployment. 


35o 


RISK AND RISK-BEARING 


summary indicates the wide dissimilarity between the plans now in 
use, the differences extending to almost every point where a difference 
is possible: 

Compensation laws may be either compulsory or elective. A com¬ 
pulsory law is one which requires every employer within the scope of the 
compensation law to accept the act and pay the compensation specified. 
An elective law is one in which the employer has the option either of accept¬ 
ing or of rejecting the act, but in case he rejects the customary common-law 
defenses are abrogated. Of the 45 compensation jurisdictions (43 states, 
Alaska, and Hawaii), 14 are compulsory and 31 are elective as to compensa¬ 
tion provisions. 

Scope or coverage. —No state compensation act, even when full use of 
the elective provisions is taken into account, covers all employees. The 
principal exemptions, in the order of their importance, perhaps, are: non- 
hazardous employments; agriculture; domestic service; numerical exemp¬ 
tions, i.e., excepting employers having less than a specified number of 
employees; public employees, casual laborers or those not employed for the 
purpose of the employer’s business; and employments not conducted for 
gain. 

Occupational diseases. —Eleven states and the Federal Government now 
include occupational diseases among the list of compensable injuries. In 
most of these states all occupational diseases are compensated, but in some 
the coverage is limited to certain specified diseases and processes. 

Waiting period. —In most of the states an injury to be compensable must 
cause disability for a certain length of time, no compensation being paid 
during this time. This noncompensable preliminary period is known as 
the “waiting period.” The most common provision is that disability must 
continue for more than one week, this being found in 25 states. 

Compensation scale. —In all but two states the amount of compensation 
is based upon wages. A number of states, however, provide fixed lump 
sums or pensions for certain injuries, but apply the percentage system to all 
others. A few states have varying percentages for different types of injuries, 
and in several states the percentage varies with conjugal condition and num¬ 
ber of children. In 19 states the amount of compensation is 50 per cent of 
the employee’s wages: in 3 states, 55 per cent; in 9 states, 60 per cent, in 
3 states, 65 per cent; and in 9 states and the Federal Government, 66§ per 
cent. 

The compensation benefits are usually modified by weekly maximum 
and minimum limits which may materially affect the amounts. It is 
undoubtedly true that under no state compensation law does the employer 
bear 50 per cent of the cost of industrial accidents and in most states he bears 
but 20 to 35 per cent. 


RISKS OF LABOR 


35i 


The benefits for death in most cases approximate three or four years’ 
earnings of the deceased employee. Twenty-three states place a limit upon 
the maximum amount payable in any one case. These maximum amounts 
range from $3,000 to $6,000. 

Most states recognize the fact that a permanently disabled workman is a 
greater economic loss to his family than if he were killed outright at the time 
of the accident, and consequently provide greater benefits than in case of 
fatal accidents. Eighteen states and the Federal Government provide that 
for permanent total disability compensation payments shall continue for 
the full period of the injured workman’s life. Twenty-one states place a 
limit upon the maximum amount payable in any one case; these maximum 
amounts range from $3,000 to $10,000. 

Partial disability .—Two methods for compensating partial disabilities 
are generally provided for. One method is based upon the percentage of 
wage loss occasioned by such disability, payments continuing during inca¬ 
pacity but subject to maximum limits. The second method is the adoption 
of a specific schedule of injuries for which benefits are awarded for fixed 
periods, the payments being based upon a percentage of wages earned at the 
time of the injury. Usually both methods of payment are provided for. 
The practice in most states is to pay a percentage of the wage for fixed periods 
for certain enumerated injuries and for all other injuries a percentage of the 
wage loss during disability. 

Medical benefits .—Three states furnish no medical service except that in 
fatal cases involving no dependents the expenses of last sickness shall be 
paid by the employer. Seven states and the Federal Government provide 
unlimited service. Nine laws place no limitation upon the period during 
which medical treatment shall be furnished, but do limit the amount; while 
seven limit the period, but do not limit the amount. 1 

It remains to consider the extent to which the risk of industrial 
accident is reduced through the operation of insurance. Insurance to 
cover this risk has two quite distinct purposes. It may be taken out 
for the purpose of protecting the employer against the hazard he carries 
under either employers’ liability or workmen’s compensation, or it 
may be required by the state in order to protect workmen against loss 
from inability of the employer to meet his responsibilities under the 
law. 

Liability insurance is voluntary .—Before the liability of employers 
was generally increased through the passage of the limiting legislation 
to which reference was made above, few employers felt it necessary 

1 Adapted from Carl Hookstadt, “Workmen’s Compensation and Social Insur¬ 
ance,” Monthly Labor Review , XVI (January, 1923), 158-69. 


352 


RISK AND RISK-BEARING 


to protect themselves by insurance against the hazard of incurring 
liability for damages on account of industrial accident. With the 
passage of laws abrogating the customary defenses, however, the risk 
became so serious that liability insurance became very common, and 
it still is valuable in states where compensation systems have not been 
introduced, and also in the case of the numerous occupations to which 
compensation requirements do not apply, and in the cases where indi¬ 
vidual employers elect to refuse to come under the provisions of 
optional compensation arrangements. This form of insurance is 
written chiefly by stock companies. 

Compensation insurance is in many cases compulsory .—Some form 
of guarantee of financial ability is required in nearly all the states 
which have adopted the principle of workmen’s compensation. The 
most common requirement is that all employers who are subject to 
the provisions of the compensation law shall either insure with licensed 
insurance carriers, or else provide what is called “self-insurance,” 
that is, satisfy the proper administrative body of their ability to carry 
the risk. Only eight or ten states make insurance absolutely compul¬ 
sory, while four make no provision for guaranteeing the payment of 
compensation in case the employer becomes bankrupt or retires from 
business. In view of the long period during which compensation 
liabilities persist, some provision to assure the continuance of pay¬ 
ments is highly important. 

Three principal types of insurance are in use, namely, state funds, 
stock company insurance, and mutual insurance. In seven states, 
an exclusive fund is maintained by compulsory contributions from 
employers, and all compensation payments are made from this 
fund. In nine others, state funds compete with private agencies, 
and in the remaining states the field is occupied only by the private 
agencies. 

Workmen’s compensation is so new that it is hazardous to venture 
an opinion as to the relative desirability of the three plans. In theory, 
a monopolistic state fund, if efficiently managed, should be able to 
furnish the service more economically than a private carrier, with its 
large selling costs and limited volume of business. The state funds 
actually in operation have made an excellent showing. Such data as 
have been published (and several of them have been subjected to care¬ 
ful investigation) indicate that the cost of administration of accident 
insurance is lower in the mutual than in the stock companies, lower 


RISKS OF LABOR 


353 

still in the competitive state funds, and lowest in the exclusive state 
funds . 1 

The effectiveness of public administration varies so widely from 
state to state, however, and also from time to time within the same 
state, that the present body of experience is hardly sufficient to over¬ 
come the hesitancy of many students of public affairs to indorse an 
enlargement of the scope of state administrative responsibility. Where 
state funds compete with private funds, the private carriers succeed 
in obtaining a large volume of business, in spite of higher costs. 

From the standpoint of the employer, the great advantage of the 
stock insurance company contract is its definiteness. The object of 
insurance is to remove uncertainty; a contract which relieves the 
employer of his responsibility in return for a contractual premium does 
this more effectively than does a mutual or state fund with its assess¬ 
ments dependent on the loss experience, so that many employers are 
willing to pay a somewhat higher average cost for the sake of greater 
freedom from uncertainty. 

Rating in compensation insurance .—The systems used in making 
rates for insurance in compensation insurance are very complex. They 
involve the application of all three of the leading principles of rating 
which were discussed in chapter xiv in connection with fire insurance, 
namely, classification, schedule rating, and experience rating. 

The starting-point in the determination of an individual rate is 
the manual rate, which is determined by a study of statistics of the 
accident rate for a given type of labor in a given industry, modified 
by allowances for probable cost of extended liability for past accidents, 
differences of experience in different states, differences in the liberality 
of different state systems of compensation, catastrophe hazard, current 
state of business activity or depression, and profit to the insurer. 

Such a manual rate, if scientifically calculated, should serve the 
double purpose of producing a sufficient amount of revenue to meet 
the requirements of compensation, and of distributing the cost as 
equitably as it can be distributed by advance calculation, without 
inspection of the individual establishment. It fails, however, to 
accomplish one purpose which it is very desirable to keep in the fore¬ 
ground of attention in all discussions of policy with regard to accident, 

1 Cf. Commons and Andrews, Principles of Labor Legislation , pp. 4 H -I 3 
(Harper & Bros., 1920); Carl Hookstadt, Comparison of Workmen's Compensation 
Insurance and Administration , p. 97 (Government Printing Office, April, 1922). 


354 


SOCIAL ASPECTS OF RISK-BEARING 


namely to encourage activity designed to reduce the number of acci¬ 
dents. 

Schedule rating is a system of individual debits and credits for 
favorable or unfavorable features of the individual risk. This type 
of rating does much to encourage the introduction of safety devices 
and the elimination of unnecessary elements of hazard in the physical 
surroundings of the workers. 

Physical surroundings, however, are responsible for only a minor 
part of the preventable accidents; morale and discipline count for 
more than do any features of plant and equipment which can be listed 
in a schedule and checked up by the inspector. To take account of 
this factor, experience rating is sometimes used. This is a system 
whereby employers, who have a sufficiently large body of employees 
to establish a probability of uniformity in the loss experience, receive 
a modification of the insurance rate in the light of any marked depar¬ 
ture of their individual experience from the general experience of the 
industry in which they are engaged. The obvious advantage of this 
system is that it gives a direct incentive to individual effort to reduce 
the accident loss; an incentive surpassed only by that which is present 
under so-called self-insurance. The disadvantage is that there is 
always present the possibility that an unusual run of good or bad luck 
will result in an adjustment of rates which is not justified by the actual 
conditions of operation. 


CHAPTER XVIII 

SOCIAL ASPECTS OF RISK-BEARING 

In this chapter attention is directed to the question of the social 
usefulness of certain institutions whose uses in connection with the 
transfer and reduction of risk have been discussed in the pre¬ 
ceding chapters. In this survey we shall consider, first, the social 
utility of the system of free appropriation of profit by private indi¬ 
viduals. Next, we shall consider the ethical significance of three 
specific devices for dealing with risk, namely, gambling, insurance, 
and speculation. Finally, the whole system of modern industry and 
trade will be compared briefly with two other systems in the light of 
its tendency to increase or decrease the risk element in the lives of 
those who live under it. 

I. SOCIAL ASPECTS OF PROFIT-TAKING 

The profit system is so integral to the present organization of 
economic life that a discussion of its merits really involves the whole 
question of the merits of a capitalistic society, to which attention is 
given in a later section of the chapter. The present section does not 
consider possible substitutes for the profit incentive, but rather 
certain points at which that system is susceptible of modification 
without the abandonment of any of the major features of the economic 
order under which we live. 

In chapter iii we indicated the relationship which exists between 
risk and profit. Profit, it was there shown, arises from the fact that 
the amount of capital which seeks employment in certain industries, 
or other opportunities for investment, is smaller than the amount 
which could be so employed in them as to earn for itself the usual 
return. The most frequent cause for such restriction of investment 
in certain lines is the existence of risk. We have not, in our previous 
survey of this topic, raised the question of th e justification of the profit 
system. What we have done is to indicate in a very broad way the 
conditions which make it possible for the individual owner-manager 
to collect a profit. Socially speaking, there can be only one justifica¬ 
tion for profit, namely, its service as an incentive to individuals to 
undertake ventures where the outcome is uncertain. There is perhaps 


355 


356 


RISK AND RISK-BEARING 


no phase of our modern industrial organization which has been more 
acutely criticized of late years than this reliance on the motive of 
private profit. To many students the system seems calculated to 
foster the worst conceivable distribution of the world’s goods—exces¬ 
sive wealth for the few and correspondingly meager returns for the 
many, while the service it renders as an incentive to productive effort 
seems unreal or at best of secondary importance. Is the criticism 
valid ? 

As with most questions of social policy, no final and absolutely 
conclusive reply to this question is likely to be formulated, for it 
involves comparing the partly known with the unknown, but we may 
find a basis for a judgment of probability in regard to it. In the first 
place, it seems dear that a limited amount of profit is socially useful, 
indeed if we are to continue the system of individual enterprise at all, 
is necessary. For unless those who place their capital in a position 
of hazard have some hope of making more than a normal rate of 
interest, capital for hazardous investment cannot be expected to 
appear. And in this sense almost all new enterprise and much of the 
extension of old and successful enterprise through new investments 
is to be classed as hazardous. Capital cannot all be put at interest. 
The existence of a “normal rate of interest” presupposes a guaranteed 
return on capital, and a guaranty on some capital is impossible 
unless there is other capital interposed between the guaranteed 
capital and the hazards of the business. 

It does not follow, however, that because some profit must be 
anticipated, it must necessarily be realized in any given case, nor does 
it follow that the whole amount of the return above current interest 
must even be held up before the prospective investor as a possible 
reward for putting his capital at risk. Some oil wells would doubt¬ 
less be drilled under a system of taxation which confiscated half the 
profits of the successful driller, without relieving him of any of his 
risk of failure, for the rewards of success in a limited number of 
cases are great enough to secure the capital, even though the odds 
against the investor should be greatly increased. 

This is the theory of the excess profits tax, to permit a tax-exempt 
return high enough to compensate for the use of capital and take a 
large share of any excess, leaving the owner, however, some share 
of the excess return frqm risks successfully undertaken as an incentive 
to his further efforts. The graduation of the tax, so as to take a 
larger percentage of very high returns, while quite justifiable from the 


SOCIAL ASPECTS OF RISK-BEARING 


357 


standpoint of ability to pay, fails to take account of the probability 
that high returns are associated with high risk. An enterprise offering 
a high return and a high risk, if taxed at the same rate as another 
offering a low return and a low risk, may be equally attractive, but 
if the unsafe enterprise is taxed heavily on its successes, and gets no 
compensation for its failures, more conservative investments are 
encouraged at the expense of risky ones. An ideal, but probably 
impracticable, application of the principle would involve the adjust¬ 
ment of the rate of excess profits taxation so as to leave the owner a 
larger percentage of his profit in cases where the risk appears in 
advance to be larger. 

Interference with monopoly profits is quite practicable and from the 
public standpoint desirable. —For instance, government has largely 
interfered with profit in the field of public utility service, where again 
and again the principle of a limited return has been imposed in place 
of the principle of individual freedom in the pursuit of profits, and 
industry has not been stifled. Here, however, it should be noted 
that the success of the limitation has arisen from the slight amount of 
risk involved in the furnishing of public services under conditions of 
monopoly coupled with steady and strong demand, and that in the 
fixing of a “fair return” due regard has been given, in form at least, 
to the degree of risk. 

In this connection an interesting question arises relative to the 
method of calculating the investment upon which a fair return is to 
be allowed. Should the investor be allowed a fair return upon the 
amount he has actually invested in the public utility property, or 
should his return be figured upon the amount which it would cost to 
reproduce that property at present price levels ? Both views have had 
numerous adherents, although it appears that, to a large extent, the 
position taken by advocates of both plans has been determined by the 
immediate situation rather than by any well-defined convictions, 
on the principle involved. In a period of rising prices, the friends 
of the public utilities are apt to be convinced that reproduction cost 
is a very legitimate basis of calculation, and defenders of the public 
interest to favor original cost, while in periods of falling prices, opposite 
points of view prevail. 

The question is too large a one for complete discussion here, but 
its connection with the problem of risk reduction makes it necessary 
to consider certain angles of it. The following discussion brings out 
an aspect of the problem which has often been overlooked: 


35» 


RISK AND RISK-BEARING 


An even more serious objection to reproduction cost, or reproduction 
cost new, as it is sometimes called, is that it tends when applied to put 
public utilities in the class of speculative enterprises. The valuation used 
as a rate base, the “value” fixed by law upon which earnings may be made, 
when found by this method depends, among other things, upon the price- 
level. If a utility company can get its property valued by a commission 
using this method when prices are high it may reap great profits and at the 
same time conceal them from the public. If the valuation be made when 
prices are low, the company may suffer great loss and at the same time 
be thought by the public to be earning current returns upon investment. 
Suppose that a utility company assembled its plant in the late eighties of 
the nineteenth century, and that a valuation was made in 1894 or 1895. 
Prices had fallen in those years until it would have cost much less to 
reproduce a plant than to build it a few years before. A “fair return” 
upon the reproduction cost in 1895 would not represent the current return 
upon actual investment made a few years earlier. Again, suppose a plant 
assembled in the winter of 1914, and that valuation by reproduction cost 
new was made in 1920. It would, in 1920, cost to reproduce the plant about 
double the amount actually invested in 1914. A “fair return” at interest 
current in 1914 upon such a valuation made in 1920 would give the investors 
an enormous profit. Let us say that the plant in 1914 cost $1,000,000. 
Net earnings of 6 per cent on the amount would be $60,000. In 1920 the 
same property could be reproduced or duplicated at about $2,000,000. 
Six per cent on this sum would be $120,000. But since interest rates have 
also advanced, the company might insist upon and obtain permission to 
fix rates to yield 8 per cent. Eight per cent on a valuation of $2,000,000 
would be $160,000, that is to say 16 per cent on the amount actually invested. 
By this simple expedient of a valuation, made to protect the public, the 
public would be called upon to pay a return upon twice the amount invested 
in the property, to tax itself in rates to give reality to this estimated value, 
and enable the owners to show a commercial value double the principal 
sum actually invested. Under a government control making use of repro¬ 
duction cost new to find the value, the commercial value of a utility property 
would fluctuate with the rise and fall of prices. A certain sum would be 
put into the property, but how much the owners could earn upon it, the 
commercial value of their investment, would depend upon all the complex 
forces which are reflected in the price-level. How much the investment 
would be worth ten years after it was made would not depend altogether 
upon honesty and ability of management and confidence and support of 
patrons, but even more upon unforeseeable contingencies, forces beyond 
control of the management, all those accidents in different parts of the 
world which influence the movement of prices. Under such a control 
effectively applied, an investor in a public utility would gamble on the 
rise and fall of prices. Instead of utility properties attracting careful 


SOCIAL ASPECTS OF RISK-BEARING 


359 


investors, they would appeal more to that class who speculate in mines and 
oil propositions. A business owned by speculators is more apt to be 
“skinned” for the sake of immediate returns, than one owned by investors. 
It is to the public interest that utility properties be owned by those looking 
for a moderate and regular return upon investment. In the long run the 
public will get better service, if the utility properties can be developed so 
as to draw this class of investors. Reproduction cost new tends to defeat 
this end, and to make utility properties highly speculative ventures. 1 

While the main point in this argument is well taken, it should be 
noted that the speculative element which is introduced by the use of 
reproduction cost is a speculative element which is present in all 
ordinary competitive business. If the cost of building shoe factories 
goes up, existing plants can presently charge prices based on the 
competition of newer factories built at higher costs, and if the cost of 
constructing such factories goes down the older plants must sooner 
or later meet the competition of the new low cost plants, even though 
it involves the writing off of a large part of their investment . 2 

The purpose in the use of reproduction cost is simply to put 
monopolized business as nearly as possible in the position of competi¬ 
tive business, to gain for the public the rates the public would have to 
pay under conditions of competition. The case for the use of original 
cost, so far as considerations of risk are concerned, must rest on the 
contention that it establishes a better situation than would maintain 
under competition, better both for the investor and for the public 
because, while the average result in periods of rising and falling prices 
taken together should be the same, the amount of uncertainty would 
be greatly reduced under the original cost plan . 3 

1 W. M. W. Splawn, “Reproduction Cost as a Basis of Valuation,” Journal of 
Political Economy , XXIX, 162-63. 

2 It is of course not implied that the cost of building factories is an all sufficient 
explanation of a given level of shoe prices. All that is involved of price theory 
is the assumption that (a) a rise in building costs will retard the construction of 
factories till prices of shoes reach a level which justifies such investment; ( b) a 
fall of building costs will correspondingly encourage building, so long as shoe prices 
remain high, and (c) the number of factories actually built is a direct factor influen¬ 
cing the output and hence the price at which shoes can be sold. 

3 If the difference between reproduction cost and original cost is due to a change 
in the general level of prices, the reproduction cost basis might lead to less uncer¬ 
tainty. Cost of service to the public and return to investors in dollars would fluc¬ 
tuate, but the fluctuation would be offset by changes in the purchasing power of 
the dollars. 


36 o 


RISK AND RISK-BEARING 


It is dangerous to limit profits if risks are great .—The fallacy 
involved in reasoning over from monopolistic to competitive condi¬ 
tions is well illustrated by the difficulties which have been met recently 
in controlling rents. Within the last few years, numerous attempts 
have been made to apply the principle of a fair return on original 
costs to the rental of dwellings, particularly apartment houses, in a 
period when the cost of construction had greatly advanced. The 
difficulty in applying this principle to such an investment is that 
while the government can restrict the investor to a fair return on his 
original investment in a period of advancing costs, it cannot guarantee 
him that return in a period of falling costs, or at least has not proposed 
to do so. Hence, the builder is confronted with the dilemma that if 
prices advance, he will not be allowed to increase rents above the 
level of a fair return on his investment, while if costs go down, he 
will have to meet the competition of new buildings constructed at a 
lower level and take a loss as a result. Hence, the construction of 
apartment houses has been discouraged by the application of the 
principle of a fair return on original cost, while the application of this 
principle in the field of monopolistic public utilities has not had a 
similarly discouraging effect. 

What is a fair return ?—A question which arises in connection 
with the regulation of profit relates to the allowance to be made 
for risk. If we are to set limits to a fair profit, determining those 
limits by a consideration of the degree of risk involved, at what time 
is the risk to be estimated ? Much of the current discontent with the 
profit system arises from the obvious fact that the businesses which 
are now most profitable are being operated, to all appearances, with 
a minimum of risk and, hence, with a minimum need for managerial 
ability. An old railroad or bank is an illustration. Should the 
maximum profit accrue to the old established successful business, 
whose managers have fewest risks to worry them ? This attitude is 
expressed by two students of labor problems, as follows: 

Do the owners and borrowers of capital assume all the risk? Profits 
accrue to them today because it is conceived that they are the initiators, 
responsible agents, and, if necessary, the losers in industrial development. 
That this is true as a general proposition seems plausible. And in certain 
fields, particularly in marketing new commodities, there is a risk that none 
but relatively few in the community are willing to assume; and the extension 
of industrial activities is at present wholly dependent upon their assuming 
it. But these cases can fairly be left out of consideration because of their 
relatively small number in proportion to the total production. Setting 


SOCIAL ASPECTS OF RISK-BEARING 


361 

aside these exceptions, and viewing the problem as industry exists today— 
not as it has been developed but as it stands today—the extent to which 
investors and enterprisers in industry assume risk is a matter as to which 
each case must be considered separately. The risk is one thing in a highly 
competitive business where the demand is new and destined to rise; it is 
another in a monopoly; it is still another in a declining business doomed to 
disappear . 1 

What is overlooked in this sort of reasoning is that every old 
conservative business was once a new and speculative enterprise, 
and the large and certain returns which these old strong businesses 
now collect are made possible by the risks they have already run, 
as well as by the risks others must now run to oust them from their 
position. Should they now be limited to a fair return upon their 
capital, they would doubtless continue to function, since the capital 
sunk in them cannot be recovered without loss, and since it is now 
exposed to comparatively little risk. Once the capitalist has success¬ 
fully run his risk, he is at our mercy, and we can, if we will, reduce his 
return to correspond to the risks he still has to run, disregarding those 
that are past. But can we do this continuously and still secure new 
capital for enterprises which have yet to prove their merit? As 
Professor W. H. Lyon puts it: 

How about an established business? Should the government be per¬ 
mitted to take advantage of “hindsight,” and after the event has proved 
of a business that its promoters were justified in undertaking it, step in 
and say that the measure of return shall be the measure of risk now 
apparent ? Or should the government make what we may call a retroactive 
estimate of the risk, and, from the standpoint of the present, attempt to 
measure the risk originally assumed ? Human judgment cannot be counted 
on to be fair under such circumstances. It is so easy now to look back and 
feel sure that the telegraph, the telephone, the Union Pacific Railway, in 
fact, practically any established business, was bound from the start to be 
successful in a large way. Yet at the beginning of all these things there 
were more thousands who believed that the anticipated profits did not 
justify the risk to be taken than tens who believed that they did. It is 
impossible from the standpoint of the present to get the same view backward 
that the standpoint of twenty-five or fifty years ago presented forward. 
It is unfair to get the measure of reward for a risk assumed in the past by 
a present estimate of the risk now existing . 2 

1 R. G. Valentine and O. Tead, Quarterly Journal of Economics (February, 
1919), p. 248. 

" W. H. Lyon, Corporation Finance, pp. 229-30. 


362 


SOCIAL ASPECTS OF RISK-BEARING 


Not only is it unfair, but as a general policy it seems certain to be 
disastrous, though it may take many years for the evil results to 
become evident. Nevertheless, it does not seem necessary to leave 
untouched every accumulation of profit, which either foresight or 
good luck has created. Nor is the question primarily one of the size 
of the profits. The limits of social interference (aside from monopo¬ 
lies) depend chiefly on the question whether the profits arise in a 
way which might reasonably have been anticipated when capital was 
invested , or are of an unpredictable character. The former cannot be 
attacked with impunity unless we provide some other incentive to 
capitalists to undertake enterprises where there is an appreciable risk 
of loss. The latter can frequently be confiscated or prevented without 
such discouragement to future enterprise, simply because they are 
recognized as being interferences of such an exceptional character as 
not to constitute a ground for fear of similar interferences in the 
future. 

For example: if a British importer of wheat is not allowed his 
profit on wheat which he has already imported before the price rises 
on account of a crop failure in Minnesota, or a rise in ocean freight 
rates, he is likely to be deterred from making similar importations in 
future years when an exceptionally good harvest or a decline in freight 
rates may bring a loss from his operations. But if an extremely 
successful submarine campaign cuts off a supply of wheat which would 
ordinarily come into competition with his importations, and forces 
competitive prices in England to unheard of levels, government or 
public opinion may safely step in and deprive him of his fortuitous 
gain. The chance of a profit on account of the change in freight rates 
or a change in crop conditions entered into his calculations and will 
enter into them in the future. The possibility of profit from the total 
interruption of commerce with the outside world did not enter into 
his calculations and will not enter into his future calculations whether 
he is deprived of it on this occasion or not. Such profits are free 
gifts, and are at the mercy of society to deal with in such manner 
as expediency in the short run seems to dictate. 

Profiteering is collecting profits which are socially unnecessary .— 
This distinction between the cases where interference with profits 
is to be justified by extraordinary circumstances and cases where such 
interference involves, or is likely to involve, an undermining of the 
incentive to further productivity on the part of capital, is at the basis 
of the concept of profiteering, of which we have heard so much in 


RISK AND RISK-BEARING 363 

recent years. To understand this concept it will be helpful to review 
its history. 

In the medieval system of social philosophy, the place of profits 
was perfectly defined. Everything had its “just price” and anyone 
who made a profit must do so either by buying below the “just price” 
or by selling above it. Hence, all profit was illegitimate, and the 
middleman was necessarily a profiteer and a parasite. Necessarily 
an exception to this doctrine was allowed in the case of foreign trade 
because it was impossible for producer and consumer to meet, but 
such trade was regarded as exceptional. With the development of 
commerce in the later Middle Ages, and the increasing importance of 
capital in manufacture and the great expansion of opportunities for 
individual initiative in the early modern period, this doctrine of the 
immorality of profits disappeared. Public opinion swung to the other 
extreme, and profit came to be thought of as the inevitable, the just, 
and the socially beneficial reward of enterprise. The “business man” 
became the social leader. 

With the development of monopoly in numerous fields in the 
latter part of the nineteenth century, the doctrine of the just price was 
partially revived in the form of the concept of a “fair return” to which 
reference has been made. Finally, during the Great War the old 
doctrine reappeared in another form, the social condemnation of 
excessive profit-taking as profiteering, and this sentiment found 
expression in numerous types of legislation and the other restrictive 
action both in America and Europe. The concept, however, was, 
and remains, an extremely vague one. Current literature abounds 
in the denunciation of the profiteer, but tests by which he is to be 
distinguished from the wholly estimable “successful business man” 
are almost entirely lacking. 

Our ideals are changing, and change requires some groping in the 
dark, but the key to the problem is to be found in the distinction drawn 
between ordinary profits, that is, profits which were, or could have 
been, anticipated with sufficient clearness to constitute a motive for 
venturing into a risky field of investment, and extraordinary profits. 
If profits are attacked only rarely, and under color of public necessity, 
or are justified by their unusual size or their extraordinary origin, 
future enterprise may not be discouraged. If they are confiscated 
persistently and as a matter of public policy, some method of pro¬ 
tecting investors against risk must be provided, or risky enterprises 
will be avoided. 


3^4 


RISK AND RISK-BEARING 


Must risk and control be closely associated? —In chapter iii the 
effect of risk in the distribution of wealth has been discussed on 
the tacit assumption that the two functions of carrying risk and 
appropriating profit are in fact closely associated with a third, the 
exercise of control. The term owner-manager was used throughout 
the chapter instead of the term entrepreneur , generally used by econo¬ 
mists, in order to keep this assumption from being overlooked. This 
assumption, which is an original basic theory of the modern type of 
private ownership in the means of production, underlies most of our 
law of property and also runs through most of our orthodox economic 
theory. In fact, the whole modern organization of production through 
a separation of “entrepreneurs” from capitalists and laborers is 
grounded on the assumption that the risk of loss from any under¬ 
taking can best be carried by those who are directly responsible for 
the policies which may bring about the loss, and conversely that the 
responsibility for control can best be exercised by those who carry 
the burden of risk. Our whole tradition of the right of the individual 
business manager to freedom from outside interference is derived 
from this conception, just as is our traditional acceptance of his 
claim to the entire profits of the enterprise. “Whatsoever a man 
soweth, that shall he also reap,” is in theory the essence of the whole 
system of private property and free initiative. Partly because men 
are believed to work more efficiently when they themselves profit 
or lose as their enterprises prosper or decay, partly because we have 
felt it unjust for one man to suffer from the results of another’s mis¬ 
management, control of business has been delegated to the risk¬ 
bearing factor rather than the lending or laboring factor in the joint 
enterprise. 

To a considerable extent, however, opinion has recently drifted 
away from this point of view. On the one hand, it is recognized 
that the specialization of owners in carrying risk is at best only partial; 
that the laborer and the capitalist are exposed to certain risks because 
the entrepreneur is unable to bear the full amount of the possible loss. 
Hence, the theory that control logically associates itself with risk seems 
to demand a partition of control as a recognition of the extent to which 
risk is divided. For instance, the demand for “ industrial democracy,” 
in the sense of a share for labor in the management of industry, is in 
part a recognition of the extent to which labor shares in risk. Like¬ 
wise the custom of placing bankers on boards of directors of corpora¬ 
tions to whom the banks extend credit is a recognition of the extent 
to which lenders share in risk. 


SOCIAL ASPECTS OF RISK-BEARING 


365 


In the next place, it is recognized that there are limits to the 
extent to which the bearing of risk carries with it as a logical corollary 
the actual assumption of control, for the reason that the risk itself 
may be reduced by transferring control away from the risk-taker to 
a hired manager whose greater expertness offsets his lack of direct 
personal interest in his results. This situation, in large part, accounts 
for the tendency to increased complexity of organization, which has 
accompanied the development of large-scale business. In small-scale 
business it is still true that most investors insist on having either 
control or protection from the risk of unfortunate control by someone 
else, but there are many who in large-scale operations are willing as 
common stockholders to subject their capital to the major risks of 
business while retaining only the merest shadow of control. 

In legal theory, of course, the common stockholders are the 
ultimate owners of the business, assuming the primary burden of 
risk and exercising the final control, but in the case of large corporations 
whose stock has been distributed among investors the control exercised 
by most of these investors is wholly imaginary. Actually the control 
is exercised by the relatively small group—officers, creditors, or active 
stockholders, who are interested enough and have ability enough to 
exercise it, and the results of the control exercised by this group fall 
only slightly on themselves. The investor’s reliance is primarily 
on their good faith and ability as witnessed by past performance, 
not on any close association between the control and its consequences. 

One important result of this dissociation between control and risk 
has been the wide spread of the practice of limited liability. An 
investor does not hesitate to intrust a definite sum of capital to 
another’s control, but he will rarely accept the full responsibility of 
ownership in an enterprise, with resulting liability for its debts, 
unless he has a real voice in its management. Hence for enterprises 
too large to be financed by those who actually control them, the 
corporation and the limited partnership are devised. The investor 
in stock limits his liability to the amount he actually invests, or to a 
stipulated sum in excess thereof. The risk of which he divests himself 
by this means is scattered among the creditors . 1 

1 Texts in elementary economics sometimes contain the question: “In a cor¬ 
poration, who is the entrepreneur ?” It may not be amiss, therefore, at this point, 
to call attention to the impossibility of applying the concept “entrepreneur” to 
any part of a corporate organization (except in a close corporation which is managed 
like a partnership). The essence of entrepreneurship is the union of control and 
risk-bearing; in a public corporation these are not united. 


366 


RISK AND RISK-BEARING 


Another modification of our traditional policy of uniting control 
and risk is found in the numerous safeguards which have been erected 
for the protection of debtors. Bankruptcy laws, exemption of home¬ 
steads, of the proceeds of insurance policies, of the tools of a trade, 
and of minimum earnings from attachment for debt, all are ways of 
transferring part of the risk of business from the owner-manager to 
his creditors, in recognition of the fact that the enterprise is in fact a 
co-operative one, in which all have an interest and in the results of 
which all may be required to share, if a strict enforcement of the full 
responsibility of the owner-manager results in hardship. 

The test of a wise social policy in this matter seems to be much 
the same as in the converse case of limitation of profits, to which 
reference was made above (pp. 362-63). What is the effect on 
incentive? The object of placing the responsibility on business 
men for loss of property intrusted to them by their creditors is to 
secure a maximum of interest and effort on their part and to induce 
lenders to part with their capital; if the proposed interference follows 
such exceptional circumstances that it will not enter seriously into the 
calculations of lenders or business men, and either retard the financing 
business or lead to wasteful management, it may be judged by its 
immediate value in relieving distress; if it extends to normally 
anticipated situations it will probably do more harm than good. 

President David Friday has made an interesting suggestion looking 
to the elimination of the waste incident to the curtailment of produc¬ 
tion for business reasons, especially in times of falling prices. 1 He 
proposes that the government should establish an insurance fund to 
protect business men from the loss of their capital. 

His argument, in brief, is as follows: The recurrent curtailment 
of production by business managers is to be explained primarily in 
terms of fear of loss rather than greed for high profits. Business men 
are willing to continue operation of their enterprises at times when 
the prospect of profit is small, provided they do not by so doing incur 
too great a risk of loss. To insure to each entrepreneur his actual 
costs, obtaining the necessary funds by taxation of successful businesses, 
would remove the incentive to stop production, and thereby prevent 
wastes of such enormous magnitude as would more than compensate 
for the social costs of administration. 

1 “Maintaining Productive Output,” Journal of Political Economy , XXVII 
(January, 1919), 117-26. 


SOCIAL ASPECTS OF RISK-BEARING 


367 


Into the administrative difficulties involved in this proposal we 
shall not carry our criticism. The social waste of underproduction 
(estimated by President Friday at $10,000,000,000 per annum) is 
large enough to justify vast expenditure on any experiment which offers 
a reasonable chance of success in eliminating it. We can even afford 
to face the certainty of numerous individual cases of abuse, if the 
general result is to increase the national dividend by half of the sum 
involved. 

More fundamental than the administrative difficulty, however, 
is the question of the ultimate social gain to be derived from the 
operation of the scheme, assuming that the difficulties of administra¬ 
tion were overcome. Proposals to relieve the business man from the 
risk of losing his out-of-pocket costs assume that these risks have no 
social value; are they not on the contrary as essential in maintaining 
a proper balance in production as are the hopes of profit ? It is quite 
true that it is the fear of loss rather than the smallness of profit that 
induces the suspension of production in periods of faffing prices and 
diminishing demand, but such curtailment is a belated recognition 
that production in certain lines has gone too far. The elimination of 
the risk, would, it appears, tend to aggravate the tendency to follow 
the lure of immediate profit by producing to excess those commodities 
of which at the preceding moment there has seemed to be a deficit. 

For example, it is now perfectly clear that at the close of 1919 
the world had been producing too much of certain perishable consump¬ 
tion goods, notably sugar, textiles, and rubber tires, and not enough 
of such durable goods as houses, street cars, and bridges. This is 
the natural tendency of production at times when it is anticipated 
that over a long period the tendency of prices will be downward. 
Men are willing to pay high prices for the goods which they buy for 
the immediate future, but balk at paying peak prices for permanent 
construction. Everyone recognized that the nation was understocked 
with buildings and public utility properties, long before it was clear 
that it was overstocked with perishables. 1 

When the latter fact became clear, production slackened, in the 
one field, then gradually revived in the other. If the result of a 

1 It is not implied that this was the only factor involved. Another factor, for 
instance, was the great difficulty in getting higher prices out of the public for such 
staple necessities as transportation, rent, and gas. It does not appear likely that 
this situation would have been alleviated by public knowledge that the corpora¬ 
tions and individuals furnishing these necessities were protected by insurance 
against business losses. 


368 


RISK AND RISK-BEARING 


guaranty of costs would have been to divert productive energy sooner 
from the field that was overdone to the neglected field, a great national 
gain would have resulted from its adoption. It is clear that this would 
not have been true, however. As things actually stood till the end 
of 1919, the risk of producing sugar seemed less than that of producing 
street cars; if this risk had been removed by social insurance it would 
still have been true that the prospective profit of producing perishables 
would have been greater than that of producing durables. Might 
not the result of insurance of costs have been to prolong the maladjust¬ 
ment by removing the fear that actually brought about the readjust¬ 
ment, leaving us with a still greater overstock of sugar and understock 
of trolley cars when the readjustment finally came? 

Insurance of costs seems to look to the immediately disastrous 
effects of readjustment of malproduction; a sound social policy 
should look to a prevention of the maladjustment, and in the author’s 
opinion, is to be secured rather through the development among 
business men of an appreciation of the risks involved in following 
blindly the guidance of prices, advance orders and profit margins, 
rather than through the elimination of those risks. 

The interest of society is not merely to secure the maximum 
expenditure of energy by productive agents; it is to direct those 
agents to the creation of the goods which satisfy a real need, and it 
does not seem probable that the assumption by a government agency 
of the risk of loss, leaving undisturbed the forces which fix the relative 
profit margins in various fines of business, will notably improve the 
apportionment we now secure. For it will very frequently be true 
that the fine of activity which seems to offer a prohibitive risk of 
loss, and therefore is neglected, wall also offer the minimum opportunity 
of profit, and therefore be neglected even though the risks are removed. 
Such an arrangement would favor the highly speculative undertaking, 
by giving the entrepreneur a chance at a very high profit without a 
corresponding risk of loss; otherwise it is not clear that it would have 
any marked effect on the distribution of social energy. 

Finally, the effect of subjecting investment and operation to such 
a degree of public control as the insurance program would involve is 
dubious. President Friday believes that the government would 
refuse to permit suspension of operation and consequent unemploy¬ 
ment if it were in the position of a guarantor of cost; is it not on the 
other hand probable that the insurance bureau would be inclined to 
demand the suspension of production whenever it appeared probable 


SOCIAL ASPECTS OF RISK-BEARING 369 

that such operation would result in loss, thereby aggravating the evil 
against which a remedy is sought ? 

II. THE ETHICS OF GAMBLING 

An estimate of the social significance of the group of institu¬ 
tions through which the transfer of risks is accomplished may con¬ 
veniently proceed by a consideration of certain aspects of gambling, 
of insurance, and of speculation. These three types of activity have 
this much in common, that all consist of the transfer of wealth from 
one person to another in a way which is contingent upon an un¬ 
known, usually a future, event. Between a short sale of wheat and 
a bet that the price of wheat will fall, or between a fire insurance 
policy and a bet that a certain house will burn, there is superficially 
a close resemblance; an analysis of the difference between them 
must get back of the form to the social and individual consequences. 

In chapter vii, we gave attention to opportunities of profit involved 
in gambling, without consideration of the social and moral aspects 
of the question. It remains to consider the justification of the tra¬ 
ditional condemnation of gambling as immoral. Is it purely a ques¬ 
tion of balancing the risk of loss against the individual’s enjoyment 
of the excitement, or are there more important social considerations ? 
The following points are suggested as having a bearing upon our answer: 

a) The gambler is in an antisocial position. —The whole drift of 
social evolution throughout the recorded history of the race has been 
toward the development of moral standards, of legal and political 
institutions, and of other agencies of social control to enforce co-opera¬ 
tion; that is, to induce or compel the individual to seek his own 
advancement through activities which tend to the advancement 
of other members of his group. The gambler, however, gains only as 
others lose. The traditional attitude of hostility toward the gambler 
rests, therefore, on much the same ground, though its expression is 
less extreme, as our hostility toward the confidence man and the 
burglar. The more efficient any of these become, the poorer the rest 
of the world becomes, and the more surely the rest of the world must 
organize to restrain the antisocial activity. 

b) Energy devoted to the improvement of the gambler's technique is, 
socially speaking , wasted. —A universal energizing of gamblers or a 
general introduction of scientific management among them would 
leave them and the world no better off, for one gambler’s gain in 
efficiency would be offset by another’s. In this respect the gambler’s 


37° 


RISK AND RISK-BEARING 


position is analogous to that of the militarist, the political stump 
speaker, and the proselyting apostle. 1 

c) Gambling tends to disqualify one for work. —On the one hand the 
successful gambler finds money coming so easily through the pursuit 
of chance that it seems a waste of time and energy to hammer out an 
income by the slow and painful processes by which most of the world 
makes its living. On the other hand, the unsuccessful gambler finds 
the fruits of his labor slipping away from him and becomes discouraged 
and is apt to pin his fate to a turn in luck rather than to a return to 
productive employment. So long as the world’s business cannot be 
conducted without work, any institution which tends to reduce the 
number of competent workers is socially undesirable. In this respect 
gambling is comparable to the institution of inheritance. 2 

d) The sum total of gambling transactions involves a net social loss , 
for it tends to increase inequality of wealth, and unequal distribution 
of wealth decreases its utility. Suppose A and B bet counters on the 
toss of a fairly balanced coin. If they play a long time the most 
probable theoretical result is that they win the same number of tosses 
and quit as they began. But, if the number of counters they hold is 
small, the chances are that before they toss a thousand times one of 
them will be out of counters and the game will stop. If they start 
even it is of course as likely that one will survive as the other, but if 
one has more counters than the other the game is loaded in his favor. 
If A, for instance, starts with ioo counters and B with io, the chances 
are that before they make a thousand tosses B will run out of counters 
and have to quit. If he has to reserve some of his counters for some 
other purpose, he is so much the more certain to quit a loser, though 
his loss will not be so great. If he reduces his stakes when his fund 
begins to get low and increases them as it grows, as he is very likely 
to do, the odds are against him still more, for every run of luck against 

1 These analogies are of course imperfect, for the increased zeal and efficiency 
of rival propagandists does tend to bring out the truth, however much they may 
as individuals seek to obscure it. 

2 For more emphatic statement of this point cf. “The Social Evil,” Outlook , 
June 28, 1912, p. 246. “Gambling likewise isolates the risk and excitement that 
are found as an element in all legitimate enterprise; and by artificial devices pro¬ 
vides for the constant recurrence of that exoitement apart from any useful work or 
worthy undertaking. Nature retaliates by taking from the man who tries to cheat 
her the inclination and the power of steady industry; the true sense of social value; 
and makes of him a burden to his family, an irritable and worthless parasite upon 
the industrial order.” 


SOCIAL ASPECTS OF RISK-BEARING 


371 


him will have to be made up by a longer run in his favor, while a run 
in his favor will be wiped out by a shorter run against him. 

This is probably the most important reason for the very large 
percentage of failures not only in gambling but in all speculative 
enterprises where the duration of the individual transaction is short 
and the scale of operations can be increased readily. For instance, 
note the cases in industry and trade in which one year of depression 
has taken away the profits of several years of prosperity. The 
expansion of operations made possible by the war profits makes the 
scale of losses on the way down bigger than the scale of profits on 
the way up. 

e) A perfectly fair gamble is bad economics .—Say A, having 
$1,000 stakes $100 against $100 on a fair and legitimate 1:1 
chance. He is balancing the chance of increasing his fortune to 
$1,100 against the chance of reducing it to $900. But in accordance 
with what economists call the “law of diminishing utility,” he will 
lose more if his wealth is cut to $900 than he will gain if it is increased 
to $1,100, for the tenth hundred provides for more urgent needs or 
wants than does the eleventh. So with each addition to one’s wealth. 
The more he has, the less the importance of one more unit; the 
unit the gambler may lose is of greater importance than the one he 
may win. 

The larger the unit staked in proportion to the total owned, the 
more important this point becomes. Loss of one’s entire fortune 
causes a far more important change of status than does doubling it. 
On the other hand, if the unit staked is relatively small the point is of 
no importance. The difference between the utility of the 999th and 
that of the 1,oooth dollar is entirely negligible. Indeed, in some cases 
the argument may be turned the other way. Suppose A buys a 
lottery ticket for ten cents, which gives him one chance in 5,000 of 
winning $500. Mathematically the bet is an even one; economically it 
may be in his favor, for the dime he will probably lose represents no 
perceptible impairment of his capital or lowering of his income, while 
the prize he may possibly win will bring him a perceptible benefit. 
This will hold even if he pays fifteen cents for the ticket. The bar¬ 
gain is now a good one for both the buyer and the seller (indirect 
moral and social losses being disregarded). The lottery thus affords 
a means of collecting from a great number of persons amounts so small 
that their psychological cost is negligible and combining them into 
units large enough to give a few people a perceptible addition to their 


372 


RISK AND RISK-BEARING 


material welfare. The advantage of this sort of gamble to the buyer 
of the small chance depends on his rigidly limiting not only the size 
but the number of his purchases to such an extent that the loss, which 
is overwhelmingly probable, will mean nothing in his standard of 
living. This is very difficult to do, but if he succeeds the real odds are 
distinctly in his favor. 

/) Nothing that has been said should be applied to the case of the 
professional gambling-house keeper. He is not necessarily a gambler 
at all; he is a business man selling entertainment and taking his pay 
through a percentage in his favor in the arrangement of odds. His 
risk is not the gambling risk at all, it is the risk common to all lines 
of business of failing to get enough business to cover overhead costs, 
with the added necessity of getting a certain volume in order to insure 
the working of the law of averages on which he depends for his income. 

g ) Against these clear costs and dangers of gambling there can 
be set simply the fact that a very large proportion of the race in all 
ages have found it enjoyable, and have been willing to pay the cost of 
supporting an expensive body of devices and organizations to enable 
them to gratify their taste for this form of excitement. The foregoing 
of this enjoyment may be a necessary part of the cost of building an 
organization in which men can live together with the minimum fric¬ 
tion and maximum satisfaction, but it is none the less a cost. 

In summary: the moral condemnation of gambling must rest 
not on its economic irrationality, for it may in many cases be defended 
as rational, either on the ground that the stake is so small as to involve 
no real loss, or on the ground that the amusement is worth the cost. 
The final condemnation or indorsement of this practice must rest on 
our judgment of the importance of the effects it produces on men’s 
ability and willingness to co-operate in the building and maintenance 
of a better social structure. 

In the author’s opinion, the weight of the argument rests with the 
opponents of gambling; the traditional condemnation of the practice 
as immoral reflects a sound judgment of the social issues at stake. 
Whether, however, gambling belongs in the list of immoralities which 
an intelligent social policy seeks to prohibit by legal enactment, or 
whether it is one of the far more numerous types of antisocial conduct 
which can more wisely be discouraged by education and moral suasion 
only, is an entirely different question. Any attempt to answer this 
question would take us too far from the field of the present study, into 
considerations of the limits of effective coercion in human conduct. 


SOCIAL ASPECTS OF RISK-BEARING 


373 


III. THE ETHICS OF INSURANCE 

As was stated above, an insurance contract is not dissimilar in 
form to a wager. The insured pays a small premium, which he may 
lose or may receive again multiplied many-fold, in accordance with 
the outcome of an uncertain event. But, though the form is the same, 
the moral aspects of the question, provided a genuine risk is insured, 
are exactly opposite. The insurance contract serves to decrease risk, 
to substitute a small but certain loss for a large uncertain one. Thus a 
net gain results, parallel to the net loss involved in a gambling con¬ 
tract. We noted above that a perfectly fair gamble is economically 
unsound for the reason that the gain, if one wins, is smaller than the 
loss if he loses, because of the operation of the principle of diminishing 
utility. The case of the insurance contract is just the opposite. 
Ignoring insurance company expenses and profits, let us assume that 
A pays $10 for $1,000 of fire insurance, knowing that the chance of 
his suffering a loss of $1,000 is exactly T ^. Mathematically, his 
bargain is neither good nor bad; economically, it is good because the 
$1,000 he may lose represents more in real sacrifice than one hundred 
times the loss of the $10 involved in the payment of the premium. 

Likewise most of the other arguments advanced in the preceding 
section to show the antisocial character of gambling, have no applica¬ 
tion, or a negative application, to insurance which covers a genuine 
risk. Neither the insurer nor the insured puts himself in a position 
where his gain depends on the other’s loss; rather they have a common 
interest in the non-occurrence of the event insured against. Energy 
devoted to the improvement of the insurance technique is not wasted, 
as is energy devoted to the improvement of the gambling technique; 
insurance does not tend to disqualify one for work, but rather encour¬ 
ages one to labor in the confidence that he will not be deprived of the 
fruits of his labors by some accidental circumstance; insurance does 
not tend to create inequality of wealth. 

On the other hand, whenever there is no genuine risk to be hedged, 
as is the case in overinsurance, and in the case of insurance on the life 
of persons who have no producing power, the arguments cited against 
gambling have full force. The following account of the early history 
of life insurance illustrates the possibility of using the insurance con¬ 
tract for purely gambling purposes. 

The distinguishing feature of the age was the “Gambling” tendency of 
nearly all the Offices. Under the title of “Insurance Wagers,” every con¬ 
ceivable description of speculation was entered into. The duration of the 


374 


RISK AND RISK-BEARING 


lives of persons believed to be on their death-bed, was a common hazard, 
and the author of Every Man His Own Brother was not far wrong when he 
said the dissolution of persons, who saw themselves insured in the public 
papers at 90 per cent, was, not unlikely, hastened by such announcements. 

Even the morality of the newspapers of that day was shocked by such 
proceedings; we find the London Chronicle of 1768 thus declaiming, “The 
introduction and amazing progress of illicit gaming at Lloyd’s Coffee-house 
is, among others, a powerful and very melancholy proof of the degeneracy 
of the time. Though gaming in any degree is perverting the original and 
useful design of that Coffee-house, it may in some measure be excusable to 
speculate on the following subjects:—Mr. Wilkes being elected member for 
London: which was done from 5 to 50 guineas per cent.:—Mr. Wilkes being 
elected member for Middlesex, from 20 to 70 guineas per cent.; Alderman 
Bond’s life for one year, now doing at 7 per cent.:—On Sir J. H. [mark the 
modesty!] being turned out in one year, now doing at 12 guineas per cent.; 
—On John Wilkes’ life for one year, now doing at five per cent. N.B. 
Warranted to remain in prison during that period:—On a declaration of w r ar 
with France of Spain in one year, 8 guineas per cent.” “But,” continues 
the sensitive journalist, “when policies come to be opened on two of the 
first peers in Britain losing their heads at 10s. 6d. per cent, or on the dissolu¬ 
tion of the present parliament within one year at 5 guineas per cent., which 
are now actually doing, and underwritten chiefly by Scotsmen, at the above 
Coffee-House, it is surely high time to interfere.” 

In the Public Advertiser of Dec. 6, 1771 [then the leading newspaper], 
we find the following paragraph:—“We have the pleasure to assure the pub¬ 
lic, from the most undoubted authority, that the repeated accounts of her 
Royal Highness the Princess Dowager of Wales being very ill, and her life 
in great danger, are entirely false; such reports being only calculated to pro¬ 
mote the shameful spirit of the gambling by insurance on lives!” 1 

IV. THE ETHICS OF SPECULATION 

The case for organized speculation is midway between that for 
insurance and that for gambling. The speculative contract which 
transfers to speculators the risk which some one must carry anyway 
is analogous to insurance in that it relieves one party of risk and enables 
him to do business more economically and efficiently. It is inferior 
to insurance in that the insurer does not as a rule get rid of the risk 
by combination. The total amount of uncertainty-bearing is not 
reduced, but the incidence is shifted to those who voluntarily elect 
to carry it. Incidentally, as was noted in chapter xi, the service of 

1 Walford, Insurance Guide and Handbook , pp. 27-28. (4th ed.; Charles & 
Edwin Layton, London, 1901.) 


SOCIAL ASPECTS OF RISK-BEARING 


375 


risk-bearing, so far as the whole group of speculators are concerned, 
is probably uncompensated, so that society as a whole gains at the 
expense of the speculative group. 

If the personnel of the futures market were made up entirely of 
hedge buyers and sellers, it would not be a speculative market at all; 
it would be simply a convenient device by which, on the one hand, 
industries using grain or cotton as raw materials, and, on the other 
hand, dealers in those commodities, could trade with one another, the 
needs of the one group for protection against falling prices being offset 
by the need of the other group for protection against rising prices. 
Unfortunately, the needs of dealers in raw materials and those of 
manufacturers who need to buy hedges do not coincide in time nor 
necessarily in volume. Consequently, a futures market without 
speculators could only be run through some such process as this, that 
if at a given season there was an excess of supply of hedging contracts 
from producers of, or dealers in, the raw materials, over the number 
required as hedging purchases by manufacturers, the price would be 
forced so low that manufacturers would be induced to contract in 
advance for their supplies of raw material, thus taking the load off 
the market. Vice versa, if there were an excess of demand for hedges 
from industries and a consequent high price, prospective sellers of 
hedges might be induced to sell their contracts in advance. Such 
a development would not mean the elimination of the speculator, 
however; it would merely mean that dealers and manufacturers had 
been given an inducement to become speculators themselves. To a 
large extent, something like this does happen, but it is not at all clear 
that there is any social advantage in having the speculating done by 
people who are also dealers in raw material or products rather than 
by specialists in speculation. Certainly the presence of a group of 
speculative traders who are ready on occasion to take either side of 
the market, facilitates the hedging process by making the market 
broad and continuous enough so that the hedger is able to make his 
trades with confidence that a contract once opened can be closed out 
again without breaking or “bulling ’’ the market. As a practical 
issue, there can be no hedging without speculation. 

It is undoubtedly true, however, that in a large number of trades 
neither party is hedging; there are only two speculators, one trading 
for a rise and the other for a fall. If all the trades were of this char¬ 
acter, the social results would be exactly the same as those outlined 
in the case of gambling contracts. There is in speculation the same 


376 


RISK AND RISK-BEARING 


unwholesome dissociation of income from useful work as in gambling; 
the same consequent undermining of the sense of the values of money 
and of work; the same eagerness to profit by another’s misfortunes; 
and the same temptation to risk more than one can afford to lose, and 
to seek to recoup one’s fallen fortunes by dishonest means. 

The question whether a speculative market serves to increase or 
decrease the net amount of uncertainty resolves itself into a question 
concerning the proportion of trades which are purely speculative in 
character. No data bearing directly on this question are available, 
but the indirect evidence indicates that a very large part of the trades 
on the Americah exchanges are purely speculative . 1 But it must be 
remembered that a hedging trade may be made between two specu¬ 
lators, neither of whom has any idea of ever owning anything to hedge. 
Suppose that A, a flour-miller, buys a line of May wheat from B, a 
speculator, in order to cover a forward contract for the delivery of 
flour; then gradually sells out the contracts as he delivers the flour. 
Some of his contracts may remain open for five or six months. But B 
has no intention of staying “short” for such a length of time. He 
buys in his contract from C, and forgets all about the transaction long 
before A is ready to close it out. C, in turn, buys the contract in 
from D, D from E, and so on, the “short side” of the contract passing 
from hand to hand till finally it is bought in from a grain house which 
remains short till delivery date and then fulfils the contract by delivery. 
In the meantime, however, A may have decided to close out his last 
remaining contracts. He sells to X; X sells to Y, and so the “long 
side” of the contract passes from hand to hand till it reaches someone 
who is willing to accept delivery, or possibly is bought by a speculator 
who has already sold it short at the other end of the line, and so is can¬ 
celed out. Most of the intermediate holders of the contract were 
speculators, not hedgers, yet each played an essential part in the hedg¬ 
ing transaction by carrying for a part of the time the risk which had 
to be carried by someone all the time. It is difficult to see how the 
situation would be better, from the social standpoint, if one speculator 
carried the risk clear through than it is with a succession of speculators 

1 Arthur Richmond Marsh estimated some years ago that not over 25 per cent 
of the trades made through the cotton futures market were speculative. (Annals 
of the American Academy of Political and Social Science , XXXVIII [September, 
1911], 276.) But the estimates given in chap, xi, concerning the volume of futures 
trading, indicate that even if it is figured that every bushel of grain is hedged three 
times on its way from the farmer to the baker the number of direct hedging trades 
is a minor fraction of the total volume of exchange trading. 


SOCIAL ASPECTS OF RISK-BEARING 


377 


each carrying it for a short time. Certainly it is much easier to find 
someone able and willing to carry the load when facilities are offered 
for getting out of the trade at will . 1 

To summarize this discussion: the same possibility of using a 
contract either for the purpose of hedging a legitimate risk or for the 
purpose of creating a gambling risk which we saw in the Lloyds con¬ 
tracts arises in connection with “future contracts” on the produce 
exchanges. When a grain merchant sells a future contract to hedge 
against a fall in prices while he is marketing his purchases of cash grain, 
or a flour-miller buys a future contract to protect himself against loss 
while he is manufacturing flour which he has agreed to deliver, he is 
securing protection against a definite risk in much the same way that 
one secures protection against an incalculable hazard through a Lloyds 
policy, but in both cases the only way that the insuring or hedging 
individual gets rid of his risk is by transferring it to someone else who 
assumes it as a speculation. The whole machinery of the produce 
exchange finds its justification in the facilities which it affords for 
carrying on certain types of business with a minimum risk and conse¬ 
quently at a minimum cost. There is no question that it is sound 
business policy to make use of the hedging market whenever a hedging 
contract can be secured on reasonable terms, but the existence of a 
hedging market presupposes the existence of a group of speculators 
who take the risk off the business man’s shoulders, and there has as 
yet been found no way to prevent these contracts being bought and 
sold in a purely gambling spirit. A, the speculator, in relieving B of 
risk certainly performs a valuable service for society, but A does not 
know whether he is relieving B of risk or buying contracts from C who 
is speculating on the opposite side of the market, and if the result is 
to impoverish A or to bring him unexpected “easy money” the effect 
is quite as demoralizing as when similar occurrences take place through 
the medium of the race course or the roulette wheel. 

In any case it is clear that the mixing of speculation with other 
types of business is likely to be bad for the other business. No busi¬ 
ness man thinks of employing his surplus funds during a slack season 
in writing insurance policies on his friends’ property, and the employ¬ 
ment of surplus funds in speculation by business men in general in 

1 The reader will not fail to notice the parallel between this process of passing 
on the risk of price changes and the practice at Lloyd’s by which underwriters 
reinsure all or part of a marine risk when they apprehend that a loss has taken 
place. 


378 


RISK AND RISK-BEARING 


order to furnish other business men with protection against price 
fluctuations is quite as unsound. This is true, not so much because 
the man who speculates as a side line lacks expert knowledge, but 
simply because it diverts energy and time from the principal business 
into the side line, and, more important, creates a new and unnecessary 
hazard affecting the working capital of the principal business. Society 
needs speculators, but the proper source for speculative funds is the 
accumulation of surplus funds in the hands of those who are not 
actively engaged in other business and can afford to take a series of 
losses without flinching in the expectation of making it back in the 
long run. The great weakness of present-day speculation is that there 
are too many people furnishing speculative contracts who, either on 
account of the needs of their other lines of business or on account of 
absolute limitation of funds, cannot stick through the long run and 
are “ wiped out” by the first or second unexpected turn of the market. 

So much emphasis has been laid upon the service of exchanges in 
making hedging possible, that there is danger of overlooking the fact 
that an exchange is a market, and as a market has a function to per¬ 
form in bringing about such an adjustment of prices as will, on the 
one hand, clear the market within a crop year of substantially the 
entire crop, and, on the other hand, stimulate an increase or decrease 
of supply by producers in harmony with changing conditions of con¬ 
sumers’ demand. As was pointed out in chapter xii, such adjustment 
is effected in part through manipulation of the carry over, but this 
method is effective only for absorbing minor fluctuations in demand. 
Both the adjustment of the carry-over and the slower but more effec¬ 
tive adjustment of production and consumption are effected chiefly 
through the agency of price; the question whether organized specula¬ 
tion assists in such adjustment is therefore of primary importance. 

The tests of a satisfactory price level are, first, does it adjust 
itself quickly and smoothly to changes in the demand or supply situa¬ 
tion as such changes become known, and, second, is it relatively free 
from fluctuations which are not the result of such changes. On the 
one hand, it is desirable that any change, whether an increase or a 
decrease, which is to be caused by a given condition, shall take place as 
soon as possible after that condition becomes known. If, for instance, 
a crop shortage necessitates a decrease in consumption, it is better 
that such decrease shall be brought about as early in the preceding crop 
year as possible, in order that the carry over from the fat into the 


SOCIAL ASPECTS OF RISK-BEARING 


379 


lean year may be large enough to equalize the consumption. In 
general, the sooner a change in price occurs the less violent it need be; 
the price-making function of the speculator is to anticipate changes 
of price-making conditions, and by his purchases and sales expedite 
the adjustment of prices to them. If his anticipations are correct, his 
purchases will be made in advance of increases in price which would 
ultimately occur anyway, and his profit may be regarded as a compen¬ 
sation for facilitating the adjustment; if his anticipations are wrong 
his losses are the penalty he pays for obstructing the adjustment. 
The amount of the profit or loss in the individual case bears no relation 
to the value of the social service or damage rendered, but as the most 
of the profits of the successful come out of the losses of the unsuccess¬ 
ful, society, outside the group of speculators, has no direct concern 
with the size of the individual profits and losses . 1 

It may be added that the operations of a skilled group of fore¬ 
casters, whose purchases and sales hasten the adjustment of prices 
to their normal level, tend to reduce the risks of trade, for the reason 
that buyers of grain and other speculative commodities, even if they 
do not hedge, carry a somewhat smaller risk of adverse changes in 
price if the market is so organized that prices at any given time reflect 
the consensus of skilled and informed judgment concerning the demand 
and supply situation. This point is of more importance, however, in 
connection with stock speculation, and will be discussed in that con¬ 
nection in a later paragraph. 

The conclusions just set forth, in regard to the tendency of specu¬ 
lation to reduce the fluctuations of price by hastening their approach, 
rest entirely upon theoretical reasoning. It would be desirable, if 
possible, to fortify them with statistical evidence, but the facts avail¬ 
able are entirely inconclusive. So many other factors enter the situa¬ 
tion alongside the influence of speculation that it is impossible to 
isolate the effects of this particular factor . 2 

1 Cf. Lavington, “The Social Interest in Stock Exchange Speculation,” 
Economic Journal, XXIII, 36-52. Professor Lavington correctly indicates that 
in specific cases the speculator’s services are enormously overpaid, but does not note 
that the rewards of successful prognostications, which promote the adjustment of 
prices to their theoretically correct level, are chiefly paid in the form of penalties 
by those whose unsuccessful prognostications retard such adjustment. 

2 The possible methods of approach seem to be four: to compare prices of the 
same commodity at the same time in different places; to compare prices at the 
same market, or in similar markets, at different times; to compare prices of different 
grades of the same commodity during the same period in the same market; and to 


3 8° 


RISK AND RISK-BEARING 


One other point must be considered, the ethics of short selling. 
Frequently the short seller is condemned for “ selling what he does not 
own”; “causing depreciation in the value of other people’s property”; 
and “dealing in fictitious commodities.” Analysis of what the short 
seller does fails to sustain the attitude which is expressed in these 
invectives. Inherently it is no more evil to cause a decline in the value 
of other people’s property than it is to cause an increase, if the decline 
or increase is caused by a change in the condition of the market and 
not a change in the usefulness of the property itself. The price of 
anything represents a compromise between the interests of the buyer 
and of the seller. If a short seller forces prices unduly low, he may 
injure those who have occasion to sell during the time of his influence, 
but he correspondingly benefits those who buy during the same period. 
Moreover, whatever he sells he must later buy, so that the net effect 
of his sales and purchases is neither to increase or decrease prices; it 
is merely to increase the turnover, just as is the case with the specula- 

compare prices of different commodities whose markets are in most respects similar 
except that some have and some have not facilities for speculative trading. None 
of these methods is satisfactory. If we compare prices of the same commodity in 
different parts of the world, we meet the difficulty that the prices in the non- 
speculative market are directly influenced by those in the speculative market, 
and vice versa. If we compare the prices of different grades of the same com¬ 
modity, we meet the same difficulty; the prices of the grades deliverable on con¬ 
tracts and those not so deliverable are interdependent. If we compare the range 
of fluctuation of prices before the introduction of future trading with the range 
since, we meet the difficulty that the introduction of organized speculation has 
been accompanied by other changes, such as the introduction of telegraphic com¬ 
munication, the establishment of grading systems, the improvement of transporta¬ 
tion and storage, and the auction system of buying and selling, which collectively 
far outweigh in importance the advent of the speculator. Comparisons of the 
price fluctuations of similar commodities, such as wheat and rye, present the 
difficulty that the prices are not entirely independent of one another. It is quite 
probable, however, that some light may be thrown on the question by more care¬ 
ful study of this last kind of evidence than has yet been made. For a recent 
attack on the question, cf. Boyle, Speculation and the Chicago Board of Trade , 
pp. 122-24, 219, criticized by the author in Journal of Political Economy , XXIX 
(January, 1921), 82-83. Brace, Value of Organized Speculation, p. 58,, and Emery, 
Speculation on the Stock and Produce Exchanges of the United States, p. 127, conclude 
from rather scanty evidence that speculation has probably increased the stability 
of prices. Usher, “The Influence of Speculative Marketing on Prices,” American 
Economic Review, VI, 49-60, concludes that the problem is not susceptible of direct 
statistical solution. Cf. Chapman and Knoop, “Effects of Anticipation in the 
Cotton Market,” Economic Journal, XIV, 541-54. 



RISK AND RISK-BEARING 


38i 


tive buyer who later sells all that he buys. What really breaks a 
market during a bear raid is the selling of weak and timid owners who 
do not reappear as buyers. 

If the short seller can frighten real owners into selling out at the 
bottom, he is enabled to cover his sales at a profit; unless they do so 
he can never profit by a fall in prices of his own making. The prac¬ 
tices of buying on narrow margins, placing stop-loss orders, and trad¬ 
ing on market gossip and surface indications are responsible for much 
more weakness of markets and artificial depression of values than is 
short selling . 1 

The other criticisms of short selling need no extended refutation. 
“ Selling what one does not own,” in order to profit by a fall in price, 
is no more intrinsically immoral than is buying what one does not want 
to own in order to profit by a rise. “ Dealing in fictitious commodi¬ 
ties,” as has been shown in chapter xi, expresses a misconception of 
what actually takes place in a futures market. The popular distrust 
of the short seller is a good example of our tendency to distrust the 
mysterious. Short selling is as useful as speculative buying. Both 
are useful just in so far as they express an intelligent judgment of the 
probable trend of prices. 

Speculation in securities .—The case for organized speculation in 
securities presents quite different features from those with which we 
have just been dealing. The advantages of this sort of speculation 
relate not to the maintenance of facilities for the direct shifting of 
risk to specialists, as is done in hedging and in insurance, but to the 
maintenance of a broad market through which securities may readily 
be bought and sold without the necessity of bidding them up in order 
to purchase or offering them down in order to sell. As was shown in 
chapter vii, such a broad market makes possible the elimination of an 
important kind of risk, namely the risk that the investor will not be 
able to get his money back when he needs it; and at the same time 
makes it possible for the corporation which uses the capital to remain 
free from the risk which would result from an agreement to repay it 
on demand. The free shifting of investments through a stock market, 
or for that matter through an active “ over-the-counter ” market, is 
facilitated by the presence of a body of speculators who stand ready 

1 This argument is much more significant in the case of speculation in securities 
than in the case of commodities, as the investment buyer is much more responsible 
for the price level in the security market. 


3 82 


RISK AND RISK-BEARING 


to buy or sell on slight changes of price, though their services are not 
as essential as they are in a commodity exchange. 

Speculation in securities, whether organized or unorganized, 
affords an illustration of specialization in risk-bearing much more 
complete and minute than that which is secured through the produce 
exchanges. Each individual carries securities involving the amount 
and kind of risk he prefers; as securities change in character they are 
passed on from one group to another. Normally, as a corporation 
grows older its securities grow less speculative; the exchange facilitates 
the process of passing them on, till they reach the status of high-grade 
investments and leave the speculative market to rest in the strong box 
of the conservative investor. The most conservative investments 
have usually passed through a speculative stage, and there are only 
two ways in which they can be carried through this period—either by 
speculators and speculative investors, or else in the hands of a com¬ 
paratively small group of persons close to the management who have 
more faith in the enterprise than the general public has any cause to 
display. 

Short selling is not as essential to the work.of a stock exchange 
as it is to a commodity exchange, but its effect is, on the whole, to 
facilitate the adjustment of market price to the known elements of 
value. As was noted in connection with a similar feature of the 
commodity markets, such an adjustment decreases the risk of the 
investor. Most buyers of securities are not able to inform themselves 
thoroughly in regard to the stability of the corporations whose securi¬ 
ties they buy, and must, to a large extent, rely on the price itself as a 
guide in determining their selections. Many buyers establish a 
definite policy of buying no securities whose yields do not fall between 
certain fixed limits. They make their selections in large part on the 
basis of the risk indicated by the yield, assuming that if the yield is 
very high or very low there must be some good reason for it. 

This is far from being an ideal method, but it is probably one of 
the best which is available to the average investor, provided the yields 
are determined in a genuine competitive market. Unless such a 
market exists, however, the method breaks down completely. Short 
selling makes it much more difficult for anyone to maintain an artifi¬ 
cially high price for a security, and then sell it to investors on the 
strength of the apparently favorable market rating evidenced by the 
price itself. 


SOCIAL ASPECTS OF RISK-BEARING 


383 


The value of this protective feature of the security markets 
would be much greater if some method were devised by which short 
sales could be made safely in a larger number of securities. As the 
case stands now, a speculator may be quite right in his judgment 
that a certain security is selling at too high a price, and must sooner 
or later decline, yet it may be unsafe for him to sell it short because 
of the risk that the floating supply will be bought up by someone 
who will then refuse to make loans of stock for the use of short sellers . 1 

The cases where the services of the short seller would be most 
useful are those where securities are being distributed by under¬ 
writers at what the informed know to be unduly high prices, yet the 
most of the certificates are still in the hands of the underwriters, so 
that it is impossible for short sellers to break the market down to its 
proper level. The uninformed are permitted to buy the security 
on the strength of the high quotations established by manipulation. 
Short selling is practically confined to a few active securities. 

In the light of the considerations set forth above, we may agree 
with the judgment of a leading economist that speculation has both 
benefits and evils, but the benefits accrue chiefly to the general public, 
while the evils accrue to the speculators themselves. One adverse 
feature of the situation, however, remains to be considered. 

We have emphasized above, and economists generally have 
emphasized, the service of a body of expert speculators in studying 
the indications of coming change, and expressing their judgments in 
purchases and sales which tend to bring the level of prices as soon as 
possible into line with all the known facts. Economists have not, 
however, generally recognized the opposite tendency involved in the 
fact that speculation, especially organized speculation, gives these 
same students a financial incentive to conceal the facts of which they 
become cognizant. 

Suppose a certain speculator obtains advance information of 
facts, which when made public will inevitably raise the price of certain 
commodities or securities. He cannot take advantage of his knowl- 

1 As this is being written, the Piggly Wiggly case furnishes an excellent illustra¬ 
tion. Stock which could be bought for December delivery at $55 was selling in 
March, 1923, around $75, obviously an artifically high price. Yet short sellers 
who attempted to take advantage of this situation suffered severely because they 
found themselves unable to get a sufficient supply of loanable certificates to keep 
them “short” until the partial payment stock could be secured. 


384 


RISK AND RISK-BEARING 


edge except by purchases, and purchases tend to cause the rise to 
occur at once, which is socially desirable. But if he can induce 
others to sell freely until he has completed his purchases he can make 
them more advantageously; thus he has a financial incentive to keep 
his news secret, and to do what he can to stimulate a belief that prices 
are actually going down. This direct incentive to speculators to 
become spreaders of darkness instead of light goes very far to offset 
the social advantage of having prices influenced by the judgment of 
special students of the market outlook. 

Finally, there can be no doubt that from the social standpoint 
much of the energy which is spent by speculators in study of the 
behavior of organized markets, and much of the time of brokers and 
their employees, represents sheer waste. The function of scrutinizing 
the news for indications of coming change in the security markets is 
valuable, but it is greatly overdone, and too largely intrusted to those 
who have no qualifications for doing it well. 

Land speculation .—The case of land speculation is worthy of 
special attention because there is a very widespread belief that the 
land speculator is especially deserving of condemnation as a parasite. 
There seems to be no basis for the assumption that the land specula¬ 
tor’s social significance is particularly different from that of any other 
speculator, or that he can make a profit out of price changes except 
by promoting those uses of land which are socially most desirable. 

In the case of land which can be rented and fully utilized during 
the time it is being held by a speculator, as is generally the case with 
farm land, there is no waste of social resources; the rental value of the 
land is no greater and no less than it would be if the land were held by 
a permanent investor. The social problems involved are those 
generally associated with tenancy. 

In the case of land which cannot be put to productive use till it 
is improved and is being held unimproved by a speculator, there is 
apparently a waste of resources, and it is in connection with this type 
of land speculation that the system of free buying and selling has been 
most condemned. Yet no speculator has any incentive to hold land 
out of service any longer than is necessary in order to reserve it for 
its most productive use. If a speculator believes that ten years from 
now his lots will be worth enough to justify putting a $100,000 building 
on them, he cannot afford to put a $10,000 building on them now, 
unless the smaller building will pay for itself in ten years so that it 
can be scrapped without loss to make way for the more productive 


SOCIAL ASPECTS OF RISK-BEARING 385 

use. In such a case it is socially desirable to hold the land out 
of use. 

In general, if the speculator is right in his judgment that his land 
will be worth enough more some years hence to pay interest on what 
he could get for it now, plus a profit, society gains by having the land 
held out of use till that time. If, on the other hand, the most profitable 
way to use the land, in the long run, is to improve it at once, and then 
scrap the improvements later to make way for better ones, it is to the 
speculator’s interest to do so or to sell to someone who will. Here, 
as in other types of speculation, the line of greatest profit coincides 
with the line of social interest. Speculators may, and often do, retard 
the use of land for purposes for which it is desirable that it be used, 
but they lose money by so doing. 

Of course, what has been said above concerning the possibility 
of profiting by dissuading others from following the line of their 
best interests, withholding from them valuable information, and 
disseminating errors, applies here, but it is probably of less importance 
than it is in the case of the organized markets. 

V. RISK-BEARING AND THE SOCIAL ORDER 

In any evaluation of our social machinery for dealing with 
uncertainty, the largest question involved is the rating which is to 
be given the present economic order as a whole, from the standpoint 
of its tendency to reduce or increase the element of risk. One of the 
chief objects at which men are aiming in their economic efforts is the 
attainment of security. Does the economic system they have 
established promote this purpose reasonably well ? 

The question is not answerable, even in theory, unless it is so 
restated as to involve a direct comparison between the economic 
order under consideration and some other order, either historical or 
hypothetical. Viewing the economic system of free enterprise merely 
as an isolated phenomenon, without consideration of any possible 
alternative system, the observer is equally justified in rendering a 
verdict highly favorable or highly unfavorable. One man is filled 
with amazement and admiration that the system works as well as it 
does; another is aghast that it does not work better; there need be 
no difference of opinion between them as to the actual facts of the 
case at all. Their difference of attitudes is merely aesthetic. As soon, 
however, as a comparison is attempted between the present order and 
some other order, we have some chance of reaching a rational judgment. 


3 86 


RISK AND RISK-BEARING 


Practically speaking, there are only two bases on which a judgment 
of any interest concerning the efficiency of the modern capitalistic 
organization can be formulated: namely, a comparison with the 
medieval small-scale non-competitive and non-speculative economy; 
and secondly, a comparison with the socialized large-scale non¬ 
competitive, non-speculative economy which, in some form, is preferred 
by most radical critics of our present-day organization. 

As compared with the situation which prevailed before the 
introduction of the machine technique, corporate organization, 
extensive commerce, and complex finance, the case is far from clear. 
In relation to the hazards which arise from man’s ignorance of the 
workings of nature, the average man is more secure than were his 
ancestors. Public and private facilities for the maintenance of health 
are far better than ever before in the history of the world; weather 
forecasting has greatly reduced the hazards of storm and flood; 
dangerous animals have been driven far from the homes of most men; 
better food, better clothing, and better shelter make man independent, 
as never before, of the powers of physical nature. The hazards of 
war also, in spite of the formidable evidence to the contrary, are 
probably less than was the case when our scientific knowledge and 
economic interdependence was less. War grows more spectacular, 
but less frequent, and though the weapons of war grow more deadly, 
the diseases of the camps kill fewer and fewer. 

Let us consider next the risks of maladjustment of production 
and marketing. It is obvious that modern methods of production 
involve a great deal more uncertainty with regard to the exact coin¬ 
cidence of desire and supply than did the simpler type of organization. 
When the medieval gildsman made a pair of shoes for his neighbor, he 
knew before beginning work that a market existed for the shoes. 
And even earlier when he was acquiring his skill or establishing his 
shop, he knew pretty accurately the course of demand for his product 
during the period when the acquired skill and capital were to be used. 

When goods are made by the modern factory process, on the other 
hand, there is no exact knowledge of the coincidence of the productive 
effort and the desire for its fruits. When the clothing manufacturer 
starts the process of making a suit of clothes, he does so in the faith 
that somewhere in the world is a man of the size and shape to fit that 
suit, and that the paths of the suit and the man will cross at the 
exact moment when the man desires to purchase a new suit of clothes. 
Viewed from the standpoint of the single transaction, such an effort 
looks hazardous in the extreme. 


SOCIAL ASPECTS OF RISK-BEARING 


387 


The degree of hazard is not to be estimated, however, on the basis 
of the probability of the single transaction’s turning out well, but on 
the basis of the average result as estimated in accordance with the 
law of large numbers. And from this standpoint the broader the 
market, the less the risk. If of 5,000 suits that were sold last year, 
9 per cent were of a certain size and 17 per cent of another size, thefe 
is slight probability that the proportion of men of these sizes in the 
next group of 5,000 buyers will differ widely from the preceding 
result. As the number of cases grows larger, the percentage of error 
grows smaller. The individual varies, the crowd remains the same. 
It is only the exceptional individual, who in size or shape fails to 
conform to the mass, whose wants cannot be supplied by the method 
of mass production. 

Most problems of risk reduce themselves finally to these two 
types: Does the increase in the value of a commodity, which will 
result from its being transported to another point in space, promise 
to offset the costs and risks of the undertaking? Does the increase 
in value anticipated from transferring a commodity by storage to a 
remote time promise to offset the costs and risks involved in the 
undertaking ? In the case of transportation, the direct and calculable 
cost is the more serious factor; in the case of storage the risk element 
is more likely to control, but in both cases the principle is the same; 
the anticipated increase in value must equal the actual known costs 
of the operation, plus the probable cost or loss multiplied by the frac¬ 
tion which represents its probability. What communication is to the 
difficulties of space, forecasting is to the difficulties of time; what 
transportation is to the difficulties of space, storage is to the difficulties 
of time. 

One of the first effects of the expansion of business into its modern 
form was a great increase in the space area involved within the cal¬ 
culations of the single unit. In the beginning this expansion of space 
involved an increase of risk. When wool was raised in northern 
England to be woven into cloth in Belgium, and worn as clothing in 
London, Paris, Spain, and Denmark, it was impossible for an indi¬ 
vidual who was responsible for the early stages of the productive 
process to know the conditions at the point where the later stages 
would be carried through, and the result was the injection of a large 
element of risk into men’s calculations. 

The later course of capitalistic development, on the other hand, 
has been in the direction of eliminating space risk. Rapid transporta- 


388 


RISK AND RISK-BEARING 


tion and improved communication through postal, telegraph, tele¬ 
phone, and radio service have made a continent, so far as effect of 
space upon risk is concerned, smaller than an old-time county. The 
trader buying wheat in New York for export has Liverpool quotations 
no more than ten minutes old, and even in markets for less stand¬ 
ardized commodities and in dealings with remote parts of the world, 
the factor of ignorance due to distance has been reduced to a fraction 
of its former importance. 

On the other hand, the risk from the other type of extension of 
the market has tended to grow more and more important. The 
modern productive processes not only involve a wider range of ter¬ 
ritory but a greater scope of time. Between the opening of an iron 
mine in Minnesota and the purchase of the resulting needle by a 
housewife in Texas, much time must elapse, and the effect of time is 
to multiply the possibilities of miscalculation. And our technique 
of reaching into the future to secure a basis for our calculations is 
vastly inferior to our technique of reaching across space, with the 
added complication that, whereas goods shipped in error from one 
point to another can generally be shipped back, goods carried through 
in error from one point of time to another can never be returned. 

To these considerations two others must be added. The risk of 
loss in a given undertaking depends not only upon the amount of 
hazard to which the capital or acquired skill invested in it will be 
exposed before the normal completion of the undertaking; it depends 
also upon the completeness and rapidity with which the investment 
can be rescued in case the adverse conditions appear. This is chiefly 
a question of the degree of specialization. The capital invested in an 
office building or a building suitable for light manufacture can be 
utilized without tremendous loss if the enterprise in connection with 
which it was originally invested proves a failure, whereas the capital 
invested in a steel plant, a stock of pogo sticks, or an equipment for 
manufacturing five-inch shells can be utilized for few other purposes in 
case the calculations of the investor prove false. It is at this point 
that the indictment of insecurity against the modern organization 
has most force, with reference both to the investment of capital and 
the investment of time in fitting one’s self for a particular type of 
labor. The unskilled laborer is dependent for his support not on the 
continuance of the particular industry in which he is employed, but 
on the continuance of activity of business in general. But the pastry 
cook must lose his investment of time in acquiring skill in manu- 


SOCIAL ASPECTS OF RISK-BEARING 389 

facturing a given type of dessert as soon as public taste turns to a 
rival delicacy. 

Finally competition may bring loss to the individual even when 
it brings gain to the group. All competitive business involves in¬ 
eradicable elements of risk. We improve the merchant’s technique 
of studying the market, and we increase correspondingly the number 
of things he must know. We may develop a technique of forecasting 
price changes, but if we share the technique with those to whom we sell 
and those from whom we buy, the difficulty of squeezing a living out 
of price fluctuations remains unchanged. If we establish a hedging 
system to relieve the merchant of the risks of price changes, presently 
competition narrows his margin of profit so that his certainty of an ade¬ 
quate return for his efforts is again removed. If we make the trader’s 
lot more secure by creating insurance companies, police forces, and 
other agencies for relieving him of risk, we attract more traders into 
competition with him. Efforts to make competitive business safe 
for all who engage in it are like efforts so to improve the standards of 
athletic coaching in a community that no one will lose any more 
contests. 

It is a striking fact, however, that the number of persons subject 
to the risks of the market and of competition has vastly expanded. 
We release the farmer from the grip of manorial custom, and leave 
him free to experiment with new methods which may greatly increase 
his income, but which may ruin him. We free the peasant from the 
soil and send him out to seek his fortune; he may rise much higher 
than his ancestors ever dreamed of rising, but he may also much 
more easily sink to pauperism. In granting opportunity, we have 
imposed risk. The average standard of living of the agricultural 
laborer has advanced greatly, but the variation in status has increased 
still more. 

In other departments of life the same thing is true. The guilds- 
man, the monk, and the soldier of the precapitalistic era all found 
their place in life as members of organizations; they rose or fell chiefly 
as those organizations rose or fell. Modern individualism has cut 
the bonds between individuals, and given them the possibility of 
choice , and with free choice goes increased risk. 

The question of the relative value of medieval and modern organi¬ 
zations, from the standpoint of the risk involved, is therefore an open 
one. The range of uncertainty has for most men increased, but the 
uncertainty arises largely from the possibility of better things; whether 


39° 


RISK AND RISK-BEARING 


these possibilities are worth the risks they entail is largely a matter 
of the individual’s preference as to the kind of world he wants to 
live in. 

The question of the incidence of risk in a socialist state, as com¬ 
pared with that in a capitalist state, is too large for complete analysis 
here, because of the extent to which a final conclusion in regard to it 
depends on estimates of such unknown variables as the effect of the 
abolition of independent business opportunities on the caliber of men 
offering themselves for public office, and the effect of the socialization 
of productive property on the individual’s feeling of responsibility 
to do faithful work. All that we shall attempt is a consideration of 
the direct effect of the change to a socialist organization on the amount 
of uncertainty involved in the productive and distributive processes. 

Clearly, a well-organized socialist state could remove much of the 
uncertainty in man’s fife. It could, as a military organization does, 
place men in definite positions from which there would be little chance 
of their escaping either for better or for worse. The risks of production 
and of the commodity market would be borne by the group as a whole, 
and in large part eliminated by combination; the risks connected 
with the market for one’s individual skill and energy could, if the 
controlling minds desired, be eliminated by cutting the connection 
between the demand for one’s service and the rate of one’s wage. 

On the other hand, such an organization might as readily operate 
on the basis of an unequal distribution of the community income to 
laborers of various kinds, with free competition between individuals 
for the higher paid and more difficult positions. If this latter method 
were followed, the uncertainty of the individual’s economic future 
might be little less than it is at present. 

Or, quite possibly, a compromise might be effected whereby the 
amount of individual liberty and consequent individual risk would be 
less than it is at present, yet greater than it would be if all tasks 
were apportioned solely by political methods, and income was divided 
equally or by some method not directly connected with the scarcity of 
the kind of service which the individual could perform. Our own 
federal civil service offers, in those who have remained in it past 
middle life, an excellent illustration of the possibility of an economic 
career which is touched with the minimum amount of uncertainty 
concerning tenure, compensation, and conditions of work; opportuni¬ 
ties for such riskless endeavor the socialist state might easily multiply. 


SOCIAL ASPECTS OF RISK-BEARING 


391 


Outside the market for individual services, the chief difference 
between the risks of present-day industry and those which we would 
anticipate under a socialistic organization would arise from the elimina¬ 
tion of the risks which arise from the tendency under competition for 
individuals alternately to accumulate and reduce stocks in anticipation 
of price changes. This tendency, which, as was shown in chapter v, 
is the major cause of the cyclical tendency of business, seems to be 
inescapable so long as individuals make their business decisions each 
in ignorance of what the others are deciding on the basis of the same 
evidence. Any system of centralized control of production, whether 
arising from governmental monopoly or from private monopoly, could 
in large part escape this weakness of the competitive system, and save 
a considerable portion of the waste which attends the alternation of 
excessive activity and stagnation in the industrial process. 1 

1 In view of the extent to which current theory ascribes the cyclical tendency 
in business to the “p ecu m ar y” organization of society, it may be well to examine 
the probable effects of socialization more carefully. By the term “p ecu m ai y 
organization” there is designated, rather inaccurately, the system of directing 
production in such a way as to produce the maximum profit for business men; 
in other words, the attempt to produce those things for which the social demand, 
as expressed in offers of payment, is the greatest, relative to the costs incurred. 
A socialistic organization would face the necessity of making a similar adjustment 
of supply to demand, but not necessarily to demand as expressed in offers of purchas¬ 
ing power (though if purchasing power were equalized the chief objection to the 
method would disappear). 

Whether production be adjusted to demand as expressed by offer of purchasing 
power, or by the ballot, or by the results of statistical investigations by experts, 
or by any other method, the critical point in determining whether the cyclical 
tendency would be eliminated, seems to be the question of centralization of control. 
A private monopoly controlled by the pecuniary calculus would be freed from the 
tendency, if its business were not interdependent with that of other businesses 
which are subject to the tendency; on the other hand, in fields where adjustment 
requires time a group of independent producers all controlled by a philanthropic 
desire to direct production into the channels of greatest social efficiency would be 
subject to the cyclical tendency if they made their decisions independently and on 
the basis of their knowledge of the same general situation. 


QUESTIONS 

1. The ultimate effect of improvements in business methods is usually to 
lower prices to consumers, yet society depends on the self-interest of 
business men, through profits, to secure the adoption of improvements. 
Is this rational? 

2. Profit is sometimes stated to be a compensation for the “‘irksomeness” of 
riskbearing. Discuss. 


392 


RISK AND RISK-BEARING 


3. Can you cite cases where profit is collected without either monopoly 
conditions or significant risk, (a) temporarily ? ( b ) permanently ? 

4. Formulate a general statement of the conditions under which profit is 
socially useful. 

5. It is frequently assumed that the placing of control in the hands of those 
who carry risk tends to prevent recklessness in the conduct of business. 
Does the history of governmental business enterprises confirm this ? 

6. Under a socialistic organization, who would take the risks incident to the 
introduction of new methods? 


APPENDIX 

REFERENCES FOR FURTHER READING 


CHAPTERS I TO IV, INCLUSIVE 

Fisher, Irving. Nature of Capital and Income, chap, xvi; Appendix I. 
New York: Macmillan Co., 1906. 

Haynes, John. “Risk as an Economic Factor,” Quarterly Journal of Eco¬ 
nomics, IX (1895), 409-49. 

Knight, F. H. “Risk, Uncertainty, and Profit.” Hart Schaffner & Marx 
Prize Essays. Boston: Houghton Mifflin Co. (Riverside Press), 
1921. 

Ross, E. A. “Uncertainty as a Factor in Production,” Annals of the 
American Academy of Political and Social Science, VIII (1896), 304-31. 
Willett, A. H. “Economic Theory of Risk and Profit,” Columbia University 
Studies in History, Economics and Public Law, Vol. XIV. New York: 
Columbia University, 1902. 


chapter v 

Clark, J. M. “Business Acceleration and the Law of Demand,” Journal 
of Political Economy, XXV (March, 1917), 217-35. 

Hansen, A. H. “ Cycles of Prosperity and Depression in the United States, 
Great Britain and Germany,” University of Wisconsin Studies in the 
Social Sciences and History , No. 5. Madison: University of Wisconsin, 
1921. 

Lavington, F. The Trade Cycle. London: P. S. King & Son, 1922. 

Mitchell, W. C. Business Cycles. Berkeley: University of California 
Press, 1913. 

Selden, G. C. “Trade Cycles and the Effort to Anticipate,” Quarterly 
Journal of Economics, XVI (1902), 293-310. 

CHAPTER VI 

Babson, Roger W. Business Barometers, 15th ed. Wellesley Hills: Babson 
Statistical Organization, 1921. 

Gaines, M. W. The Art of Investment, chap. vii. New York: Ronald 
Press, 1922. 

Hansen. Op. cit. 

Jones, E. D. Investment, chaps, xv-xvii, inclusive. New York: Alexander 
Hamilton Institute, 1917. 

Jordan, D. F. Business Forecasting. New York: Prentice-Hall, 1921. 

Mitchell. Op. cit. 

Review of Economic Statistics , passim. 

393 


394 


RISK AND RISK-BEARING 


Vance, Ray. Business and Investment Forecasting. New York: Brookmire 
Economic Service, 1925. 

CHAPTER VII 

Chamberlain, Lawrence. Principles of Bond Investment , chap. ii. New York: 
Henry Holt & Co., 1911. 

Lavington, F. The English Capital Market, chaps, xiii-xv, inclusive. 
London: Methuen & Co., 1921. 

chapter vm 

I 

Atwood, A. W. The Exchanges and Specidation. New York: Alexander 
Hamilton Institute, 1919. 

Emery, H. C. “Speculation on the Stock and Produce Exchanges of the 
United States,” Studies in History, Economics and Public Law, Vol. 
VII. New York: Columbia University, 1896. 

Huebner, S. S. The Stock Market. New York: D. Appleton & Co., 1922. 
Meeker, J. E. The Work of the Stock Exchange. New York: Ronald 
Press, 1922. 

Pratt, S. S. The Work of Wall Street, rev. ed. New York: D. Appleton 
& Co., 1921. 

II 

Chamberlain, Lawrence. Op. cit., chap. xl. 

Dewing, A. S. The Financial Policy of Corporations, Vol. II, chaps, vii-ix, 
inclusive. New York: Ronald Press, 1920. 

Moulton, H. G. The Financial Organization of Society. Chicago: Uni¬ 
versity of Chicago Press, 1921. 

CHAPTER IX 

Browne, Scribner. Practical Points on Stock Trading. New York: 

The Magazine of Wall Street, 1918. 

Gaines, M. W. Op. cit., chap. x. 

Gibson, Thomas. The Pitfalls of Speculation. New York: Moody Maga¬ 
zine & Book Co., 1916. 

-. “The Facts about Speculation,” serially in Financial World, 1923. 

Selden, G. C. Investing for Profit. New York: The Magazine of Wall 
Street, 1913. . 

chapter x 

Chamberlain, Lawrence. Op. cit. 

Clay, Paul. Sound Investmg. New York: Moody’s Magazine & Book 
Co., 1915. 

Gaines, M. W. Op. cit. 

Jones, E. D. Op. cit. 

Jordan, D. F. Investments, rev. ed. , New York: Prentice-Hall, 1921. 
Lagerquist, W. E. Investment Analysis. New York: Macmillan Co., 1922. 



APPENDIX 


395 


CHAPTERS XI, XII 

“American Produce Exchange Markets,” Annals of the American Academy 
of Political and Social Science , Vol. XXXVIII (September, 1911). 

Clark, F. E. Principles of Marketing , chap. xvii. New York: Macmillan 
Co., 1922. 

Emery, H. C. Op. cit. 

Hibbard, B. H. The Marketing of Agricultural Products, chaps, x-xiii, 
inclusive. New York: D. Appleton & Co., 1921. 

Weld, L. D. H. The Marketing of Farm Products, chaps, xv, xvi. New York: 
Macmillan Co'., 1916. 

CHAPTERS xill-xvn, INCLUSIVE 

Annals of the American Academy of Political and Social Science, Vol. LXX 
(entire) (March, 1917, Part I “Life Insurance”; Part II, “Fire Insur¬ 
ance”; Part III, “Accident and Compensation Insurance.” 

Blanchard, R. H. Liability and Compensation Insurance. New York: 
D. Appleton & Co., 1917. 

Fackler, E. B. Notes on Life Insurance. New York: Spectator Co., 
1907. 

Gephart, W. F. Principles of Insurance, Vol. I, “Life”; Vol. II, “Fire.” 
New York: Macmillan Co., 1917. 

Hamilton, W. H. Current Economic Problems, chap, xi, rev. ed. Chicago: 
University of Chicago Press, 1919. 

Hudnut, J. M. Studies in Practical Life Insurance. New York: New York 
Life Insurance Co., 1911. 

Huebner, S. S. Life Insurance. New York: D. Appleton & Co., 1915. 

-. Property Insurance, rev. ed. New York: D. Appleton & Co., 

1922 

Riegel, Robert, and Loman, H. J. Insurance Principles and Practices. 
New York: Prentice-Hall, 1921. 

Willard, Charles E. The A B C of Life Insurance. New York: Spectator 
Co., 1917. 

Woodbury, R. M. Social Insurance, an Economic Analysis. New York: 
Henry Holt & Co., 1917. 

Zartman, L. W., and Price, A. A. Yale Readings in Insurance, rev. ed. 
Vol. I, “Personal Insurance”; Vol. II, “Property Insurance.” New 
Haven: Yale University Press, 1920. 

CHAPTER XVIII 

Emery, H. C. “Speculation,” in Everyday Ethics. New Haven: Yale 
University Press, 1910. 

Knight, F. H. Op. cit., chaps, xi, xii. 






I jg IHK I B I . •; •- 










*• 












INDEX 


Abandonment, notice of, 321-22 
Abstracter, bonded, 332 
Accident, industrial, 345-57 
Admiralty bonds, 330-31 

Agricultural production, as a barometer 
of business, 92-95 

Analysis of securities, industrial, 190- 
200; public utility, 200-202; rail¬ 
road, 200-202 

Annuities, life, 259-62; 276-80 

Assumption of risk, in industrial ac¬ 
cidents, 348 

Automatic premium loan, 264 
Automobile insurance, 322-23 
Averaging down, 160 

Babson Compositplot, 103-6 
Bank acceptance, 327-28 
Banking barometers, 96-101 
Barometers of business, 86-101 
Barometric data, sources of, 114-15 
Basis contract, in future trading, 206 
Blanket policy, in fire insurance, 298, 
3 00 

Bond house, see Investment bank 
Bonds, investment, 187-88; written by 
surety companies, 330-32 
Bond tables, error in, 182-83 
Bradstreet’s index of prices, 87 
Brookmire barometers, 106-8 
Brokers, stock exchange, relations with 
customers, 131; classes of, 137-47 

Bucket shop, 135 

Builders’ risk policy, in marine in¬ 
surance, 322 

Bureau of Labor Statistics’ indices, 87 
Business cycle, phases of, 63-71; causes 
of, 71-83 

Business failures, as a business bar¬ 
ometer, 90-91; statistics of, 117 

Business forecasting, chap, on, 84-115 
Business managers, qualifications of, 
43-45 

Business problems, analysis of, 48-53 


Calendar trading, 164, 218 
Call loan rate, 161-62 
Capitalist lender, risks assumed by, 
33-34 

Chicago Board of Trade, 208-14 
Clearing methods, used by stock ex¬ 
changes, 131; by boards of trade, 
211-12 

Coinsurance, in fire underwriting, 299- 
301; in credit insurance, 324 

Collision insurance (automobile), 323 

Combination, reduction of risk by, 19- 
21 

Commission houses, 137-38 
Commission rates, on stock sales, 137-38 
Compensation, reduction of risk by, 26 
Composite barometers, 101-14 
Conflagration hazard, 290-91 
Consolidated Stock Exchange, 148 
Construction and the fire hazard, 290 

Constructive total loss, in marine in¬ 
surance, 321 

Continuous instalment, in life in¬ 
surance, 259-62 
Contract bonds, 331 
Contracting out, 60-61 
Contributory negligence, in industrial 
accidents, 348 
Control and risk, 364-66 
Convertible term policy, 243 
Co-operative method of reducing risk, 
18 

Cornering, 131 

Corporate suretyship, 328-31 
Credit insurance, 324-26 
Criminal bail bonds, 330 
Crisis, 68-71 
Crop insurance, 323-24 
Curb market, 130, 147-48 
Customs and internal revenue bonds, 
33i 

Dean Schedule, in fire insurance, 316, 

318 


397 


39 8 


RISK AND RISK-BEARING 


Deferred annuity, 279 
Depository bonds, 331 
Depreciation and fire loss, 289 
Depression, business, 63-64 

Direct settlement, in future trading, 
210-n 

Disability clause, in life insurance 
policies, 243, 280-81 

Disbursement of life insurance funds, 
258-69 

Distribution clause, in fire insurance 
policies, 298 

Diversification, 202-5 

Employers’ liability legislation, 348-49 
Endowment life policy, 243 

Ethics of gambling, 369-72; of in¬ 
surance, 373-74; of speculation, 
374-85 

Excess profits tax, 356-57 
Excess floater, in fire insurance, 298 
Expense, in life insurance, 258-59 
Exposure, and the fire hazard, 290-91 
Extended insurance, 263-64 

Factory mutuals, 305 
Fair return, 357-60 
Farmers’ mutuals, 303-4 
Fellow-servant doctrine, in industrial 
accident, 348 
Fidelity bonds, 330 
Fiduciary bonds, 330 

Fire insurance, chap, on, 288-319; 
automobile, 323 

Fleet insurance, 322 

Floating policies, in fire insurance, 298; 
in marine insurance, 322 

Fraternal insurance, 272-76 
Friday, David, 366-68 
Foreign government bonds, 188-89 
Futures contract, 205 
Futures markets, 207 

Gambling enterprises, 125-26; ethics 
of, 369-74 

General policy, in fire insurance, 298 

Government bonds, United States, 187; 
foreign, 188-89 

Gross premium, in life insurance, 251 
Group insurance, 269-71 
Guaranty and suretyship, chap, on, 
327-35 


Harvard General Index of Business 
Conditions , 108-14 
Hazard, fire, 288-91 
Hedging, 60; chap, on, 223-56; 375-78 

Idle car figures, a barometer of business, 
88 

Improvement (a phase of the business 
cycle), 65-66 

Indemnity, doctrine of, in fire insurance, 
292, 293 

Indices of general business conditions, 
see Barometers of business 

Indorsement, as guaranty, 327-28 

Industrial corporations, reports, 88-90; 
securities, 190-91; analysis of finan¬ 
cial position, 194-200 

Industrial insurance, 271-72 
Insurable risks, 320 

Insurance, field of, 57-59; speculative, 
59-60; against unemployment, 342- 
44; against business losses, 366-68. 
See also Life, Credit, Fire, Crop, 
Title, and Miscellaneous Insurance. 

Interest rates, a business barometer, 
98-101; adjustment to risk, 121; and 
life insurance, 250-57 

Inter-insurance, see Reciprocal insur¬ 
ance 

Internal revenue bonds, 331 

Investment, distinguished from specula¬ 
tion, 124-26. See also Securities. 

Investment banking, 152-55; ethics of, 
188 

Judgment, business, 7-8; 45-55 
Judicial bonds, 330 

Labor, risks of 33-34; chap, on, 336-54 

Land speculation, 220-22; 384-85 

Large numbers, law of, 19, 29-30 

Level premium, 243-44 

Liability, in industrial accidents, 347-48 

Liability insurance, automobile, 323 

License bonds, 331 

Life annuities, 243, 259-62, 276-79 

Life insurance, chap, on, 237-87 

Limited orders, 146, 157 

Limited payment life insurance policies, 

243 

Liquidation, a phase of the business 
cycle, 68; of debts, as an investment, 
117-18 


INDEX 


399 


Lloyd’s, insurance, 59-60, 305-6 
Loading, in life insurance, 251, 257-58 
Loans, policy, 264-69 
Lost security bonds, 331 

Manipulation, 173-74 
Margins, 138, 209, 212 
Marine insurance, 320-22 
Market analysis, 12-15 
Market orders, 146, 157 
Market risks, 3-7 

Marketability (of securities), 185-86 

Miscellaneous property insurance, chap, 
on, 320-26 

Monopoly, as a source of profit, 42-43 
Monopoly profits, interference with, 
357-59 

Monthly income policy, 279-80 
Moral hazard, 291-92, 322, 323 
Mortality charge, in life insurance, 251 
Mortality tables, 248-50 
Mortgage clause, in fire insurance, 298- 
99 

Municipal bonds, 187-88 

Mutual insurance, life, 246-47; fire, 
303-5; tornado,322 

Named policy, 322 

Natural premium, 244 

Net premium, 251 

New York Cotton Exchange, 214 

New York Stock Exchange, 129-40 

Occupancy and the fire hazard, 290 
Occupation bonds, 331 
Odd-lot dealer, 144-47 
Open policy, 322 

Optional settlements, in life insurance, 
259-64 

Overinsurance, 291-92 
Over-the-counter market, 150-51 
Owner-manager, risks assumed by, 33- 
34 

Paid-up insurance, 263-64 

Participating policy, 244 

Permit bonds, 331 

Personal loans, risk in, 121-22 

Pig iron, a barometer of business, 91-92 

Pit scalping, 218 


Policy, life insurance, 241-45; fire, 
295-98; marine, 320-22; title, 333-34 
Policy loans, 264-69 
Premiums, see Rates 

■Profit, 34-43; insurance of, 301-2; 
social aspects of, 385-91 

Profiteering, 362-63 

Prices, as barometers of business, 86-87; 
as affected by speculation, 378-79 

Probabilities, calculation of, 27-31; 
classes of, 45-46 

Produce exchanges, organization and 
purposes, 205 

Property damage (automobile) insur¬ 
ance, 323 

Prosperity, 67-68 

Protection and the fire hazard, 290 
Public official bonds, 330 

Public utilities, analysis of securities, 
201-2 

Pyramiding, 158-59 

Railways, reports of, as a business 
barometer, 87-88; securities, anal¬ 
ysis of, 200-202 

Rates, in life insurance, 248-58; fire, 
313-19; marine, 322; automobile, 
323; compensation, 353-54 

Real estate titles, insurance of, 331-35 
Reciprocal insurance, 306-13 

Recovery, a phase of the business cycle, 
65-66 

Rediscount rate, effect on expansion of 
business, 99-100, 

Renewable term policies, 243 
Rent insurance, 301-2 
Reproduction cost and fair return, 
357-59 

Research, reduction of risk by, 11-15; 
limitations of, in the social sciences, 
17-19 

Reserves, reduction of risk by, 21-26; 
in life insurance, 251 

Reversionary annuity, 279 

Riders, in fire insurance contracts, 29S 

Ring settlement, 211 

Risk, defined, 1; sources of, 2-5; 
methods of reducing, 1*1-36; as¬ 
sumption of, 33-34; a source of 
profit, 40-41; and control, 43, 365- 
67; transfer to specialists, 56; adjust¬ 
ment of interest rate to, 121; factor 
in investment policy, 181 


RISK AND RISK-BEARING 


400 

Risk-bearing, specialization in, 56, 119- 
21, 364; and the social order, 385-91 

Scalping, 158 

Schedule rating, in fire insurance, 315; 
in compensation insurance, 354 

Securities, market for, 128; distribu¬ 
tion of, 151-56; analysis of, 186-93; 
speculation in, 381-84 

Short sale, of stocks, 138-40; ethics of, 

380- 81 

Single premium insurance, 243 
Socialist state, risk in, 390-91 
Space risk, 387-88 

Specialist, on stock exchange, 143-44 

Specialization, in risk-bearing, 33-34, 
56, 119-21, 364; of capital, a source 
of risk, 388 

Specific policy, in fire insurance, 298 

Speculation, chaps, on, 157-80, 205-22; 
in land, 220-22, 384-85; in securities, 

381- 84 

Spot market, 226-27 
Spreading, in futures, 219 
Stock clearing corporation, 131 

Stock companies, in life insurance, 246- 
47; in fire, 302-3 

Stock Exchange, New York, 129-40 
Stock prices, a barometer of business, 
95-96 

Stop-loss order, 146, 158-60 
Surplus, in life insurance, 251 

Surrender values, in life insurance, 262- 
64 

Tailing on, 218 
Tape, ticker, 133 
Tax exemption, 183, 187 


Technical position, 161-63 
Term insurance, 243 
Theft insurance (automobile), 323 
Three-quarter value clause, in fire in¬ 
surance, 301 
Ticker, 132-33 

Time and motion study, 15-17 

Time policies, 322 

Time risk, 122-24; 387-88 

Title insurance, 332-34 

Tornado insurance, 322 

Torrens System, 334-35 

Transfer, in futures markets, 211-12 

Transfer of risk, methods, 32-33; ex¬ 
amples, 56-61 

Two-dollar brokers, 142-43 

Underwriting of security issues, 328 

Unemployment, of productive factors, 
24-26; of labor, 337-45; insurance, 
342-44 

Universal Mercantile Schedule, 315-17 
Use and occupancy insurance, 301-2 

Valued policy, in fire insurance, 293; in 
marine insurance, 321 

Voyage policies, 322 

I 

Wages, and the risk of accident, 346-47 

Warehouse bonds, 331 

War risk insurance, 281-86 

Wash sales, 131, 174 

Weather forecasting, 2 

Weather map reading, 218 

Whole life policy, 243 

Wire houses, 142 

Workmen’s compensation, 349-54 


PRINTED IN THE U.S.A. 


B 173 82 




































































wv v > vsaRrv v'^w x v jfs' 

'•.7* A <* Of!v ,6* "••?• A O "'Trr* . 

4* +, G ♦V/7#b I * ^ «A • ( rf555W# ^ G 


’’o ■( 


*0* 

% ' ^ * A '\.V-^' / %'•••’•** A .. ^ 

• iv- *> v .jAL% <%> jy ••••* *> v 

’• %A •'£$& \/ %A S' • 

. y\. Wm- y% If* ,/v v vw 

• at* ««* *o.»« a ♦Tttv* .(r ^ '° • * * 




• • 



■*b / : 


4 ••* Ar , Vp 

f>X .in, *> 




*' 0 ^o V. •'’• <♦* .... *<*„ •*• „f° ... «t 



«* «£k A ► 

w * 




*A 

_ s J? ^ °. 

•♦ - 9 + r 0^ v fc *o 



. A-* 

* ^ ^ 


* *y. 




V 

- 0 ^ . *r* 

_. ': *b/ :gte '^o'll 

. if 10 * ISMS’.' >"V ••'®R- rf 10 * < 

V •”' A... *••• a 0 .. V *•<’• <?* ... °4 


,:*•* **> \? r »v^r'♦ ^ n 1 *®- v > v* •»”* 

'% %.J /dflta. :'d&k\ %A .\ H 

* 5 '» _.v^. 



y °i 




^'C, 


vV 'Cl 



<, •■'TV.* . 0 T O, '...* 
V. A P.^ ,.''*. ***0 


c'-'Cp : • aV-* 

,* Jr % “!fvV^* y ^ * 

• 0^ 'o.;* A -y 

n 9 • Deacidified using the Bookkeeper process. 

,*^7 • < Lc^tv** 'v Neutralizing agent: Magnesium Oxide 


Treatment Date: Jan. 2011 




* 

* ^ 

^ PreservationTechnologies 

A WORLD LEAOER IN COLLECTIONS PRESERVATION 

<L* ill Thomson Park Drive 

Cranberry Township, PA 16066 


.0^ A A . » • (724)779-2111 


.‘VV' 


* • 


<? o • » * / > \> • * * «p A> a V * <6 

» v> <A •^5^^“- •y' V ♦ JR/7^5 2 ,% ^ A* « *^\XVdf\* ^ 

. ~A .v^siv. ^ ^ -^ia* f 


•»b v 4, : 


o V 


- ^=£*!Mi»&=v * c,-> vP- ° . 

<> *'T7i• A % *• 

- ^ A ,*1^% °o A" • 


. * * A 


- » w- ♦ jfi C 

r V *■-•'./... 

.<y • •,*•♦ v 

• a -is^Sr. * 

vp v* * 

• «v** - ^taHiy * A 'Cr 

* ** ** 



* • ♦ • 


»• 


V o 0 V ♦ ^ 


<i> *y 


•^o 4 


- ”0 V 


,<T 


* 

**. % 0 « V 
* 

• * 0 ° A v<. 




* <V y V^ •* 

„ .* ^ *<► • 

? -<»•** A <!\». * * • * 

. *©. ,/ ^ 

J ^ f\\WVA - tV 1 

v .v^ssjibp 



. - 

, > v "«v -:vv'** '* * *-. 

/ V" A 

0° siaz*.\ * A ' 

*6$ 



.0° V '*•.’•* A 

••. \A :Mk \f ;M§; \f : 

^ 'CflL 0 V/Y»«\\v ^ * ^/ 5 


C/ J\. 

* AX <}>•. *> 

♦ wflV ^ * 

> ♦ ,'* v ^ 1 « fA O. ” o ♦ » m \ * ’'y 

\ >L C° 0 A / 





* 


•’* v / V' 


- c u ♦ 

: ^ o 4 • 

„• ^ °* \ 

.o« ,.•••.. v 4 V / 

^ .A * fimm • ^ A ; 





o. AV * 
++# • • 


_9> 

tp V 


v V^ - ® c* v jv •WW*" A ^' ^ '.^7 

^ °/o% ♦ ^ -!N 9 ^ % ^ ^ 

*o,i* A ♦ • • A* A p m. 

. *0 4> fp^ .-^*. °o A *^V. V 

*,% A 0 c^v. a ’■of « ^ 




> * ** 


r ^o 


o V 




i- 0 '\, « 

r *v a c o *ta^' o 5 ^ ''^ / '** a 

l 0’ .IV*. **. „ v .’yfiv*. A V y. A .V 




r* av ♦ 
<*wV ® 


<A V w i 

V ^ 




; '-Wm : v ^ °*y 

.% y'.-^-.\. /.-^- »•> 


V 





MAY 82 




N. MANCHESTER, 
INDIANA 46962 





•o’ ^ A %* 

A **>. V < *>. 















































































































































































































